Optimal offshore allocations under new Regulation 28 limits

Optimal offshore allocations under new Regulation 28 limits

On 23rd February 2022 the South African Minister of Finance changed the rules for local retirement funds by raising their maximum offshore allocation from 30% to 45%. The significance of this change can’t be overstated. In the STANLIB Multi-Strategy team, we believe that how South African investors respond to it could be the most important determinant of their returns over the next decade.

Optimal offshore allocations under new Regulation 28 limits
David McNay

David McNay

Senior Portfolio Manager, STANLIB Multi-Strategy

The big news

For international readers, or those in SA who somehow missed the news, on the 23rd February 2022 the South African Minister of Finance raised the Regulation 28 limit on retirement funds’ offshore allocation from 30% to 45%. We have conducted in-depth research on how the new limit would have changed optimal strategic asset allocation over the last two decades and how we think investors should react to it going forward. We have developed some rules of thumb, but every investor will have a different optimal offshore allocation based on their required real return and willingness to hedge offshore risk.   


STANLIB’s multi-asset funds offer individual investors a good way to actively manage offshore risk and opportunity. This article is a summary of a longer paper in which we share our detailed analysis, available here.


Building multi-asset portfolios: not for dummies

Designing multi-asset portfolios that will produce reliable, inflation-beating returns is both an art and a science. We leverage science to understand the historical correlations between asset classes, allowing us to build portfolios which achieve the most return for a given level of volatility (the so-called ‘efficient frontier’). To add further complexity to portfolio construction, the new Regulation 28 limit is forcing serious investors to simultaneously revisit their offshore allocation and their approach to currency hedging. Outstanding quantitative skills are a non-negotiable for multi-asset portfolio managers these days. Meanwhile there is an art in accurately forecasting how asset classes might perform over the next few years, considering current valuations and the likely path of policy and macroeconomics.


Below we show the ‘efficient frontier’ of portfolios that investors with perfect foresight would have built in 2003 to achieve optimal risk-adjusted returns to the current day. The black line shows the returns (Y-axis) and volatility (X-axis) of the portfolios on the frontier, the colours behind show how the portfolios’ allocations to domestic and offshore assets (hedged and unhedged) evolve at each point on the frontier. To make this exercise as relevant as possible we have suspended disbelief for a moment and allowed the new 45% offshore limit throughout the period.

What we observe is that if you had been able to hedge currency risk, your best strategy would have been to maximise your offshore allocation and then hedge some of the currency. If you didn’t have the wherewithal to hedge the rand you would have been best advised to set your offshore allocation in line with your required return (or risk appetite). The chart below shows the efficient frontier and asset allocation choices of unhedged investors.

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Full details of the universe, data and the methodology are contained in the white paper.


The offshore attraction

South Africa is a small corner of the world’s economy and financial markets. South African GDP is less than one half of one percent of global GDP and the market cap of the Johannesburg Stock Exchange is less than the combined value of the world’s eight largest listed companies. None of this has stopped South African equities from producing superb returns in the past: studies[1] show that South African equities have produced real returns of more than 6% per year over the long term. As the chart below shows, however, the last ten years have been a hard road for SA equities: global equities have left them in the dust, validating South African investors’ historic scepticism about the country‘s prospects and exacerbating their traditional appetite to get capital out of the country.

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Our current long-term view is that SA equities will produce returns in line with global equities, but with higher volatility. Our strategic preference is therefore to diversify offshore in all asset classes to create some insulation from South Africa’s perceived political and economic uncertainty.


Why hedge the Rand?
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1. Hedging the currency improves risk-adjusted returns and broadens the investment universe


In theory, diversification into offshore markets should lower the risk of a South African portfolio but the volatility of the rand offsets this benefit to a significant degree. The rand has often moved by more than 20% against the dollar in a twelve-month period (and sometimes as much as 60%). Over the last 19 years the rand has average annualised volatility of about 17% against the dollar.


Hedging the rand removes currency volatility, as well earning an SA investor positive carry. This can dramatically improve the risk-adjusted returns for South African investors on many offshore asset classes which might otherwise look unattractive. This is particularly true for fixed income assets which are less volatile in themselves.


As an example, from November 2003 to June 2022 a representative index of global sovereign bonds would have returned about 9% per annum. If a South African investor had owned that index without hedging the rand, they would have experienced annual volatility of over 17% to make that return. If they had been able and willing to hedge the rand, they would have improved the return slightly but experienced dramatically lower volatility, about 3%.


2. You get paid to hedge the rand

It feels like a painful fact of life for South African investors that the rand steadily loses value, but many people don’t appreciate that over time the actual depreciation in the spot value has been more than offset by the positive carry that is available from hedging US dollars into rand. Investors are effectively paid to take the hedge.


This ‘positive carry’ is explained by the difference between interest rates in South Africa and the US. FX forwards (contracts agreeing future FX prices), are the most basic form of hedge. The price at which buyers and sellers will agree today to trade rand for dollars at some point in the future is a function of ‘covered interest rate parity’ (CIRP), an example of market efficiency in action. CIRP explains the future path of the rand/dollar price as a function of the difference in interest rates in South Africa and the US. The market sets forward prices at levels at which traders cannot make riskless profits by borrowing rand, using them to buy dollars, putting those dollars in the bank and simultaneously agreeing a forward contract to sell them for rand again in the future. We explain this dynamic in more detail in our white paper available here.


In pictures: STANLIB’s indicative strategic asset allocation
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For investors able and willing to hedge currency risk, our analysis clearly suggests that they should move toward their offshore allowance at the 45% limit and then hedge more or less of the rand according to their risk appetite (i.e., targeted returns): more for lower risk portfolios, less for higher risk portfolios. Eliminating currency volatility improves risk-adjusted returns for South African investors across many offshore asset classes, but particularly in less volatile instruments like global bonds.


A rough rule of thumb would be to hedge half the offshore allocation, hedging a bit more in low-risk portfolios and hedging a bit less in more equity heavy portfolios. This is because the portfolio construction benefits are larger when hedging bonds than hedging equity.


For investors who are unable or unwilling to hedge currency risk, offshore allocation should correlate with risk appetite, rising from 20% for the most conservative investors to the maximum 45% for the most aggressive. The difference is that South African cash has provided positive real returns with zero volatility (by definition) meaning a conservative South African investor could grow the real value of their savings with very little risk; we see positive real returns on cash persisting but at lower levels than we have seen in the past.


Simply put, the higher an investor’s targeted rate of return the greater their offshore allocation should be, and if they can hedge the FX risk then they should do so. We have framed our thoughts through the lens of the increased offshore limit, but they apply to all South African multi-asset investors. STANLIB applies a similar process and thinking to portfolios with different asset class universes, constraints, time horizons and return objectives. Our white paper presents our detailed analysis of how the new 45% offshore limit would have affected optimal investment strategies in the past and how STANLIB’s strategic asset allocation framework looks in light of the change to Regulation 28.


[1] See Triumph of the Optimists by Dimson, Marsh and Staunton or the Credit Suisse Global Investment Yearbook 2022 by Dimson and Staunton.

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