International investment: A key element of diversification
Investors are regularly reminded of the wisdom of having a diversified portfolio. By combining investments that exhibit different return patterns, large fluctuations in individual investments can be smoothed out. This means that the overall portfolio can benefit from the different return sources in aggregate, but with lower volatility of returns compared to just holding one of these investments in isolation. Portfolio risk increases when one is exposed to a range of assets, markets, sectors and currencies that behave in a similar way.
As the diagram illustrates, it is critical to reduce downside risk. Avoiding big losses is a proven way of enhancing longterm returns. CONCENTRATED MARKETS POSE RISKS We believe widening the opportunity set is crucial when a domestic market is concentrated. The South African equity market, as represented by the FTSE/JSE All Share Index (Alsi), is a concentrated market. While the index currently consists of approximately 165 constituents, the five largest stocks by market cap have a combined weighting of 39.4%. The Alsi 40, which includes the 40 largest stocks, represents the SA large-cap universe and makes up 83% of the market’s total market capitalisation.
In a concentrated market where performance is dominated by a few large- cap shares, investment managers often end up chasing the same stocks. This serves to further push up the share prices of a few market favourites and asset bubbles can become a real risk.
THE CONCENTRATED DOMESTIC EQUITY MARKET MEANS TRUE OPPORTUNITIES FOR DIVERSIFICATION ARE LIMITED. ONE WAY FOR INVESTORS TO WIDEN THEIR OPPORTUNITY SET IS BY INVESTING OFFSHORE AND TAP INTO A GLOBAL UNIVERSE OF OPPORTUNITIES:
While managing volatility is important, the valuation of offshore assets should also be a key consideration. Looking at the price earnings ratio for the South African stock market, many investors regard the market as being fully valued. While some offshore equity markets have run hard, the large universe of shares means many opportunities remain for astute managers to uncover. Steady, if unspectacular, global growth coupled with subdued inf lation should keep global interest rates low and be generally supportive of corporate earnings. In turn, this should be positive for global equity markets.
For South African investors who invest offshore the volatility of the rand against developed market currencies remains a major concern. In this regard, t he rand has appeared particularly vulnerable over the past three years.
Some investors may wonder about the wisdom of investing offshore at the moment, given the weak rand. In our view, attempting to predict major shortterm movements in the rand is not the premise upon which investors should base their offshore investment decisions. Investors who try to time their entry into an offshore investment based on the perceived value of the rand are taking dangerous risks.
Exchange rates represent not just relative l ong-term macroeconomic f u nda menta l s , but al s o market sentiment. It is this market sentiment that is responsible for the volatility in our exchange rate. What we do know is that, over the medium to long term, relative pricing power and the economic growth prospects of a country are useful in predicting the long-term direction of its currency. And on both these counts, SA can expect to face a steadily declining currency. On a relative pricing power basis, the rand is currently priced not too far from fair value against the US dollar. So while short-term market f luctuations in the currency are to be expected, they should not deter investors from making offshore investments.