APRIL 2022

As our forward-looking views change, and as opportunities and threats adjust, we adapt our strategies. We have a rebalance coming in the next week and a bit, specifically for our South African investors and their Rand based portfolios. The gist of the rebalance is as follows:

Equity
A reduction in SA Equity in favour of Global Equity
Bonds and Cash
A reduction in SA Cash and Global Bonds, in favour of SA Bonds

There is more meat to this piece, so if you are interested, you can read both my and Brandon Zietsman’s strategic views below. Brendan de Jongh rounds out the piece with a high-level view of the technical changes within your portfolios.

F&A views

Our view is to protect each of our clients’ livelihoods here in SA, without losing options due to unique SA risks. For South Africans, this is notably exposure to SA markets, alongside the Rand. This is not to say there is no opportunity in SA, but rather to say there is also risk in SA, as well as opportunities elsewhere.

F&A has continued to increase offshore exposure in our clients’ solutions. We have done this both in their Rand held solutions, but also by actively taking Rands offshore, into USD / GBP and investing them globally. We aim to build solutions which do not fail and so this stance is a continuation of this.

As some of you may have seen, there have been adjustments to Regulation 28, which governs, for example, how much equity and / or offshore allocation we can have within the pre-retirement solutions (RA’s, pension & provident preservers) we build. Offshore allowance has increased from 30% to 45% of holdings, a substantial change. This is massively positive and welcomed and aligns to our already existing views. It is something we will actively take advantage of.

Aside from the changes to offshore limits within Reg 28, PMX increasing their holdings of SA Bonds is also welcomed (effects both pre-retirement and discretionary portfolios). The SA Bond asset class is both globally competitive as well as complimentary to the equity positions we hold.

Both of these adjustments are long-term views. As is the case with calls of this nature, success may well not be immediate. A continuation of Rand strength for example, may make these adjustments look poor over the short-term. While all strategic updates are made with our client’s best interests at heart, we are not immune to short-term runs and so if we look like fools in the near future, please bear with us (we are hoping we don’t!). Over time, we are confident our calls will be proven right.

Our partnering with PMX and the wealth of specialists and resources at their disposal, means we yield to their professional views on opportunities thrown up by legislative changes as well as recommended adjustments to asset allocation. The fact that their views align to ours, of creating further resilience within client solutions, as well as protecting against SA specific risks is testament to our shared values and principles. If you have the energy, I encourage you to work through Brandon and Brendan’s pieces below!

PortfolioMetrix decision on new Regulation 28 limits

This piece is compiled by Brandon Zietsman, CEO and Head of Investments at PortfolioMetrix.

KEY TAKEOUTS

Following recent changes to Regulation 28 we will be increasing the global exposure in affected portfolios.
This will bring these portfolios more in line with the asset allocation of our existing discretionary (unconstrained) portfolios.
These portfolio changes have been carefully considered and we believe the long-term investment case of increased global diversification is compelling for investors.

INDUSTRY STANCE

Several managers have announced that they will not be increasing offshore exposure yet in multi-asset funds that are subject to Regulation 28. For some, this may be due to various constraints that have not been extensively discussed, while many have cited the attractiveness of SA assets over offshore assets. One can certainly formulate a good argument to support this view, as much as one can construct the counter-narrative.

On previous occasions, some prominent SA managers have argued that the optimal exposure for SA investors is in the region of 50%, while many have railed against Regulation 28 as an anachronism that harms long-term return prospects and exposes investors to unnecessary risks. Nevertheless, there is probably a high level of discomfort moving ahead of the herd and the potential performance differentials that may result.

We are also cognisant that many multi-asset funds are extremely large and the “risk-neutral” trade to establish higher offshore weights mainly involves substituting global equity for SA equity. This requires a dramatic reduction in SA equity holdings and many large funds do not have the liquidity to do so without negatively impacting local asset prices.

THE PORTFOLIOMETRIX STANCE

Investors pay us to apply our minds, experience and skill to the best of our ability. Ignoring the herd requires discipline and commitment to the primacy of mandate over short-term business risks. As such, we will be making use of the flexibility afforded by the new limits and will be significantly increasing global equity at the expense of SA equity.

The following arguments underpin that decision:

1. DISCRETIONARY REFERENCE POINTS

Unlike many managers, we have always run a full range of discretionary multi-asset portfolios in parallel with our Regulation 28 portfolios. These are unambiguously optimised for SA-based investors to provide the best expected risk-adjusted returns in rands over time. Regulation 28 portfolios are optimised in rands but with constraints explicitly incorporated.

We made significant upward adjustments to the offshore weights in our discretionary range in 2020 for the following reasons:

The size of the global opportunity set across securities, sectors, currencies and jurisdictions (SA assets form a miniscule part of this)
The extensive risk mitigation opportunities offered as a result of this breadth
Reduced exposure to SA single-factor country, company and sector risks and associated shocks
The relative ease with which one can increase offshore exposure (up to a limit) without increasing expected rand volatility, while significantly reducing latent risks
Difficulty in supporting the intellectual case for the extent of excessive, persistent home bias, which has been a peculiarly South African phenomenon.

There is no theoretical or conscionable reason (other than regulatory constraint) to support a difference between rand-optimised Regulation 28-constrained portfolios and discretionary portfolios with the same risk mandate.

2. TACTICAL/VALUATION CONSIDERATIONS

As mentioned, we are fully aware of the merits of the investment case for SA asset classes and concerns around some global asset classes. However:

We believe the industry norm for offshore weights will correctly settle at a much higher level in due course and remaining at current offshore weights (if one is not constrained by mandate, liquidity/size or access to specialist skills) is an extremely large tactical position, requiring commensurately large conviction. We think such conviction levels are inconsistent with the level of uncertainty in the world.
While we have certainly been prepared to apply moderate risk-based tilts to our asset allocation, we are deeply sceptical about any manager being able to get macro-economic and asset class valuation calls consistently right. The evidence suggests that the best laid plans often get torpedoed by unforeseeable events (predictably).
While SA assets may be attractively priced on a relative basis, the background risk in the world could very easily render pure valuation-based arguments moot. Global geopolitical risk (which has favoured SA thus far) is high and the course of future events is hard to anticipate, which can play out in unpredictable ways.
If we weren’t prepared to move our Regulation 28 offshore weights upwards, consistency would suggest that we move the offshore exposure downwards on our (similarly risked) discretionary portfolios – a significant move that would be hard to support.

3. RISKS TO THIS POSITION

Where one has positioned portfolios differently to peers, the result will be relative out-or-under performance. In investment management, this can aid or impede business prospects. PMX has benefited from significant, steady outperformance over the well-known “balanced” peer-group over our 11-year track record, and we are conscious of placing this in jeopardy. However, principle needs to trump new business prospects and there is also the possibility that this move could widen the performance gap in favour of PortfolioMetrix portfolios.

What are the main downside risks to this move?

The rand continues to strengthen against global currencies, underpinned by benign inflation domestically and higher inflation offshore. High real yields on our bonds and yield spreads versus global bonds are also rand supportive.
SA equities outperform global equities, which is a possibility supported by relative valuations.

What are the main upside risks to this move?

SA assets are not shielded from major risk events and a significant global sell off will typically be magnified in emerging equities and currencies. Current market resilience is underpinned by idiosyncratic events in commodity markets, which can reverse.
While fundamentals are strong, we have seen the rand trade far from its theoretical value for protracted periods. These changes will help protect against the sharp dislocations in the rand we have become accustomed to.
As part of this re-optimisation, we are increasing our exposure to attractively priced SA bonds, which are used not only to underpin inflation-plus returns, but also to balance risk. They buffer portfolios against better-than-expected SA outcomes associated with a decline in bond yields.

Valuation considerations aside, we do not believe that the structural constraints on the SA economy (exacerbated by political inertia) suggest earnings growth that will command an outsize equity risk premium over time, although this doesn’t help predict equity returns over the short-to medium term.

CONCLUSION

These portfolio changes have been carefully considered and the long-term structural/strategic case is compelling for investors. However, the performance of markets and currencies is unpredictable, as are events in the globe and domestically. This means that portfolios are likely to out or underperform the peer group who have not or are yet to increase offshore weights.

In the event that these changes result in outperformance, investors are typically easy to manage. If the converse is true, it is essential that the strategic, long-term nature of how we manage money is understood and that it is not in our philosophy to take large punts on asset classes (which not increasing offshore implies).

We will be implementing these changes in custom mandates, the multi-asset unit trust funds and model portfolios. We will send a separate email shortly detailing timing and the changes at an asset allocation level for affected portfolios.