What a revised Regulation 28 means for investors

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The offshore allocation limits for institutional investors like pension funds were recently increased from 25% to 30% and the special allocation to African investments (outside South Africa) from 5% to 10%.

This means that investors may now allocate up to 40% of assets outside South Africa in terms of Regulation 28 of the Pension Funds Act, which governs the maximum exposure retirement funds may have to various asset classes. Effectively investors could also invest this full 40% in the rest of Africa.

The announcement, made in the Budget in February, came in the wake of criticism that asset allocation caps – particularly the 25% related to offshore exposure – were negatively impacting investment returns and the outcomes for members in retirement.

But a change to the asset allocation limits does not necessarily mean that investors should immediately take advantage of the opportunity and rush offshore or even that they will be in a better position in the long run if they were to do so, a portfolio manager says.

The background

Richo Venter, portfolio manager of STANLIB Multi-Manager’s balanced funds, says over the past few years, low-equity balanced funds had an average offshore exposure of around 15% to 17%. Medium-equity and high-equity balanced funds had an average offshore allocation of just above 20%.

Thus, even in an environment where the offshore exposure was capped at 25% (excluding Africa), a lot of managers did not utilise the maximum limits allowed.

Venter says recent discussions with fund managers suggest most managers believe there is an opportunity to increase global exposure to 30%, but since certain managers expect the rand to remain relatively strong for some time, they don’t think it is currently a good tactical option.

However, a handful of managers – one of them Clyde Rossouw who manages the Investec Opportunity Fund – have already moved closer to the 30% allocation.

With regards to Africa, there hasn’t historically been an appetite to invest aggressively into the continent, Venter says.

Managers like Allan Gray have made small allocations to Africa from time to time, but it does not seem that the higher limit of 10% would make any real difference at this stage since managers are generally nowhere near an allocation of even 5%.

Venter says African investments are new territory to most local managers. Most managers don’t have dedicated resources to analyse opportunities on the continent. Currency, political and liquidity risk should also be considered and it may be expensive to trade and transact.

“But that said, there is obviously huge opportunity in Africa for investors that are willing to do the appropriate investment research and take on calculated risks.”

Considerations 

While the asset management industry has welcomed the increased offshore allocation of 30%, there are a number of things investors should consider.

Venter estimates that at least 50% of the earnings of locally listed stocks are derived from abroad. A share like Naspers has the highest weighting in the JSE All Share Index at about 18%. Through its holdings in Tencent and other offshore businesses, a vast majority of Naspers’ income is now derived from abroad. Thus, if investors utilise a higher offshore allocation, their portfolios will increasingly be exposed to a foreign earnings stream. It will therefore be important to consider potential mismatches between assets and liabilities (for example the portfolio earns income in foreign currency but pensioners incur costs in rand).

Importantly, Venter says, the currency exchange rate pass through (ERPT) has come down over time, with most studies attributing this effect due to the introduction of inflation targeting by the SARB. ERPT is now estimated at only 20%. In other words, if the rand depreciated by 10% (causing imports to become more expensive), inflation is expected to increase by roughly 2% due to this depreciation, with a lag of a few months. Some global exposure is therefore helpful to hedge liabilities and provide diversification, but too much might not be appropriate. Alternatively, investors could invest as much offshore as they require for maximum diversification and hedge out the currency risks, but hedging is typically complex when many currencies are involved and comes at a cost.

Global exposure offers great diversification options and provides exposure to shares and instruments that can’t be accessed locally. However, Venter expects South African stocks to marginally outperform global equities (as measured by typical global indices like the MSCI World) in the very long run due to the developing attributes of South Africa versus the developed markets bias of global equities. This thinking is based on STANLIB Multi-Manager’s long term equilibrium asset class return expectations.

STANLIB Multi-Manager’s optimisation model – which is used as one of multiple inputs in their portfolio construction process – suggests that a 25% global allocation is probably sufficient for investors in a typical high-equity balanced fund with an inflation plus 6% target.  Venter says their initial analysis shows that a high- or medium-equity balanced fund doesn’t necessarily need more than 25% global exposure in the long run. In a low equity portfolio, 20% is probably enough to provide investors with enough diversification and an appropriate return over time.

However, this doesn’t mean that STANLIB Multi-Manager or its managers won’t make use of the higher 30% (40% with Africa) limit to take advantage of shorter-term opportunities.

Venter says their modelling suggests that in the long run, global exposure should primarily focus on equities and that fixed income assets like cash and bonds should primarily be accessed in the local market. However, from a qualitative perspective global bonds can be a great diversifier during a financial crisis and should not be dismissed as an investment when constructing a portfolio. Tactically, asset managers can also add alpha or manage risk by shifting between global asset classes.

Other potential opportunities include global property and African equity.

“We’ve seen in the past there is a lot of diversification benefits when you bring in African equity into your portfolio, which is something we are also researching at the moment to see if we can access great African equity managers cost efficiently.”

Venter says while the higher offshore allocation is a positive development, it doesn’t mean that every investor should utilise the maximum 40% immediately.

“Think quite carefully. Get the right mix of assets. Understand that local equities are becoming more and more globalised so you do get a lot of exposure to global through many of the local listed equities. It [a higher offshore allocation] is not necessarily a decision that you need to make overnight.”