In the current investment environment offshore investments are an enticing option, says Stephen Katzenellenbogen, private wealth manager at NFB Private Wealth Management.
Although investors could easily be forgiven for being emotionally charged given the prevailing economy, investing offshore should always be driven by a sound investment rationale, principles, and strategies – but never by emotion which tends be irrational and ill-thought through.
South Africa’s post Covid economic recovery has been off a low base. The muted recovery has been driven by an unsustainable growth in government borrowings and a widening fiscal deficit.
As these ratios deteriorate and South Africa sinks further into a debt trap, lower credit ratings are likely. Currently Fitch is the only rating agency with a more positive outlook on South African GDP.
The only way out of this downward debt trajectory is inclusive economic growth. However, doing business in South Africa has become more difficult and regulatory reform has lagged. Economic growth requires faster reform and real spending cuts.
Despite these factors, investors should not necessarily be exclusively bearish on the rand; with an improving current account and general positivity around the medium and longer term returns from emerging markets there are certainly factors that promote a stronger local currency.
Purchasing Power Parity (PPP) modelling done by Ninety One Asset Management predicts that at a Rand Dollar exchange rate of R15.40 to US$1, the local currency should depreciate at an average of 1% per year over the next 10 years.
Currency forecasting is far from an exact science, but it does give you a point of departure for any deliberations. In a nutshell, the ZAR should depreciate against currencies supported by a lower inflation rate. However, this needs to be assessed from your departure point, in other words, is the currency currently strong, weak, or fairly priced at the time of making your assessment. Then there are some bigger picture questions like whether the Rand should be a fundamentally weak currency, in other words, always trading at a discount to fair value.
In terms of offshore investing, when is a ‘good time’ to buy currency? If you look at the long-term trend of the ZAR versus the USD, it has depreciated over time with a long-term rate of depreciation equal to roughly the difference between the USA and SA inflation rates.
What this means is that the timing of the purchase becomes less relevant given the currency’s long-term depreciation trajectory. If possible, avoid buying at an extreme low, for example just after Nenegate or the days after news of Covid broke. If you can avoid buying at an extreme low, the purchase price is not likely to matter too much down the line.
The timing of the currency purchase also becomes less relevant if the plan is to regularly externalize money which means you will end up rand-cost-averaging this way.
The diversification benefits of investing in to foreign – also known as offshore – assets are well documented. The benefits to the risk return characteristics of a portfolio are clearly positive and support less volatility and better long term returns.
Beyond diversification, the benefit of offshore investments is only there if it allows the investor to earn a return that is commensurate or higher than the return they can earn investing in South Africa.
Fundamentally, a foreign investment into a developed economy should provide a lower return, ignoring the currency effect, than investing in South Africa. This is because the base return – made up adding inflation and the risk free interest rate – is lower.
If this is the case, why should investors invest offshore? There are many reasons for this, including the ability to access markets and sectors that are not available in South Africa. The local equity market is relatively small on a global scale and does not fairly represent a globally diversified portfolio. Investment into a broad set of sectors and sub sectors are small compared to a market like the US, where an investment in the pharmaceutical sector, for example, offers a broad and diversified range of companies.
At any point in time the price of the South African market as a whole or at an individual stock level may be higher or lower than other countries. Investors looking for exposure to a retailer, for example, could find that Walmart is cheaper than Pick n Pay. Given this, why not buy the lower cost alternative?
In the same way that share prices may differ from one country to the next, the economic conditions may differ and this in turn will have an impact on the success of companies with exposure to the local economy. Ideally, all investments must be allocated to areas with the highest possible return accompanied by the lowest possible risk.
The assessment of market attractiveness moves beyond merely shares and considerations includes things like bonds, interest rates and property opportunities.
Ultimately, offshore investments are made because investors can enhance their portfolio diversification and get access to much broader and deeper markets with the second degree benefit of diversifying away from country and currency concerns. In addition, they provide protection against poor local economic policy which may push the country over the fiscal cliff and cause a spike in inflation and interest rates, and result in, inter alia, the ZAR weakening further. This is not to say that you should not have a local component to your portfolio but rather that you should almost always have a foreign component.
As far as the practical mechanics of investing into foreign assets is concerned, investors have the choice of either choosing to invest via a locally issued product that invests into foreign markets (a feeder fund) or they can invest directly offshore via their single discretionary (R1 million per annum) or foreign investment (R10 million per annum) allowances.
Given that investors can invest into the same fund or shares via a feeder fund and a direct offshore investment, there are two other considerations that need to be factored in. The first is that when an offshore investment is made directly, the investor is allowed to redeem the investment to a foreign bank account in their name and reinvest or buy – property for example – another investment in that market or another foreign market. A feeder fund, on the other hand, is redeemed to the investor’s South African bank account.
The second consideration is that if the investment is made into an asset with USD exposure and the ZAR weakens against the USD, the taxability of a direct offshore investment is favourable.
As an example, a R10 000 investment into a feeder fund at the time when the exchange rate is R10/$, which is redeemed later on when the investment has grown to R20,020 and the exchange rate is R20/$ would gain the investor R10 020 and the investor will be taxed on that gain.
In the context of a direct offshore investment, on the other hand, the hard currency growth is $1 ($1000 grows to $1001) and the taxable gain is R20. While this example may be extreme, the difference between a taxable gain of R20 and R1,020, when the actual return is the same, is quite different.
An asset swap, although owner dependent, is a mixture of both the above. In this instance the investor will get taxed on hard currency gains, but the investment will have to be redeemed back to South Africa.
The type of product chosen to hold an offshore investment – an endowment wrapper, direct unit trust or direct shares, for example – will influence the tax and estate treatment as well as any probate or situs consequences. All these issues need to be factored in.
Ultimately, if done for the right reason and the right way the benefits of investing offshore can be significant.
- By Stephen Katzenellenbogen, private wealth manager at NFB Private Wealth Management.