For many years we have been consistent in our belief that offshore investments offer a far better set of opportunities for our South African-based investors than local options. At the same time, some of our domestic investors may need to protect themselves against the volatility that the local currency and the global equity markets may cause. Therefore, unless their local income requirements are truly insignificant when measured as a proportion of their overall asset base, it isn’t necessarily appropriate for clients who need to draw a consistent rand income to have 100% exposure to offshore markets.
Our approach for these clients is to balance a focus on offshore equities for long-term growth, with short-duration fixed-income exposure in South Africa to provide for their income requirements.
Harvesting South African yields while mitigating currency risk
We gravitate towards short-dated income funds rather than long-dated South African government or corporate bonds because the latter amplify volatility over the longer term, increase exposure to South Africa-specific risks, and don’t offer compelling returns over time.
Given the fact that our analysis shows that a buy-and-hold position in bonds does not tend to outperform lower-risk income funds over the longer term, we see bonds only as a short-term trade that can be profitable when yields fall. We, therefore, don’t favour holding bonds as a consistent weighting in portfolios. Bonds are also strongly correlated to the rand and don’t protect portfolios in a risk-off environment in which global equities fall.
Short-dated income funds can offer a stable income in rand terms, meaning that clients won’t risk repatriating money when global equities markets are down. This option enables us to take advantage of yields in South Africa that outstrip inflation and are higher than in developed markets. It is important to remember, however, that the rand’s tendency to weaken over time will inevitably negate much of this yield differential. (It’s also worth noting that dollar yields are currently above inflation for the first time in many years.)
Why we’re betting on offshore equity markets
South African equities have significantly underperformed global developed market counterparts, especially the US, since the peak of the commodities supercycle and the subsequent Global Financial Crisis. We are not at all convinced by the narrative that the JSE is cheap and that local equities offer better value than international equities.
With South Africa expected to barely muster 1% in annual GDP growth going forward, local companies will struggle to deliver attractive returns. The greater opportunity set offshore, plus the likelihood of continued rand weakness over the long term, leads us to strongly prefer global equities over local for the growth portion of portfolios. Some factors that support this thesis are:
- The JSE offers limited scope to invest in sectors such as big tech (the only option is TenCent via Naspers/Prosus), and mega pharmaceutical companies like Novo Nordisk, which is held in one of our preferred offshore funds.
- It’s also prudent from a risk management perspective to invest in a portfolio of multinational businesses that earn their revenue globally and, thus, have inherent currency and country diversification.
- We don’t have the quality of local businesses listed on a constantly shrinking JSE.
- Rand-hedge mining shares and JSE-listed groups with international exposure such as Richemont and Naspers have underperformed global peers. Furthermore, their performance in discretionary portfolios will be taxed on the rand gains as compared to measuring the gains in hard currency when funds are placed directly offshore.
A two-pronged approach
In conclusion, the steady fixed-income stream is the side of our barbell that ensures a stable rand income for the clients that need it. The other side of our barbell, where we prefer a focus on quality global equities, is the one that does the heavy lifting for optimal long-term capital growth. It is worth mentioning that we have also avoided local and global property for years. As a result, rather than investing in a blend of all the different asset classes, we’re focusing primarily – but not exclusively – on the two components of the risk spectrum. Our two sides of the barbell meet the needs of investors who require a combination of income and growth, plus protection against South Africa-specific risks, thereby offering a defendable, balanced approach.
*For clients who need to have some non-equity exposure but don’t require a rand income, we currently recommend an appropriately domiciled global fixed-income roll-up fund. In such a fund, the interest generated is not distributed and taxed annually as income. Instead, clients will pay capital gains tax when and only when they sell units in the fund and it is also the dollar gain that is taxed, not the full rand gain. Read our article to learn more.
Similarly, we prefer to house the above-mentioned South African income funds in local retirement funds, where possible, as the interest is not taxed as income and the monthly amount withdrawn is taxed at the same rate, regardless of the underlying asset classes (in other words, equities or cash) in which the retirement funds are invested.