Using diversification to cut through the fog

29 June 2018

Globalisation and the information age have forged a more fluid world, not just from an investment perspective, but also from a social awareness standpoint. It’s a world which challenges investors to look beyond their own back gardens.

The latest conversations to come out of the World Economic Forum in Davos earlier this year highlighted the important emergence of the knowledge economy as well as inclusivity across global economic structures. With political uncertainty diminishing the certainty of stable returns, the case for geographic diversification has seldom been stronger. However, one only has to scan the African continent for notable political shifts that have dramatically changed the outlook for 2018 and beyond to appreciate the new opportunities on the horizon.

If one assumes fair pricing of country specific risks, then these risks should be fully reflected in all asset prices. This means that one way to reduce exposure to such risks would be to look elsewhere. Investors would invariably diversify their wealth to reduce the risk of their portfolio losing total value. After all, because good diversifiers generally have weak, negative or no relationship with other asset classes they may maintain, or even increase in, value when other asset classes in the portfolio lose value.

Often when country risk spikes, asset prices elsewhere may not react or could even move in the opposite direction. For example, during the global financial crisis, South African bond yields spiked, meaning the value of South African bonds declined, while United States bond yields trended lower, meaning that the price of those bonds rose as investors searched for safe havens. The same happened during South Africa’s ‘Nenegate’ fallout in December 2015, and more recently the opposite unfolded as positive political changes locally resulted in a return in investor confidence. 
In contrast, concerns over United States trade policy and fiscal stability have seen bond yields creep steadily higher following United States President Donald Trump’s election to office (among other reasons, such as the signalling of higher rate policies from that country’s Federal Reserve).



Often it is said that for emerging market investors the best home for your offshore allocation is in developed markets. And the opposite is said to be true for developed market investors. But is this really the case? For simplicity’s sake, let’s consider offshore diversification from the perspective of a South African and a developed market investor.

The correlation table above reviews the diversification benefit potentially gained in accessing African equity markets.

For the year ended March 2018, the Ashburton Africa Equity Opportunities Fund has returned 45% against the MSCI Africa ex-SA Index which returned 28%.

Shown here, the diversification benefit is very clear, not just for a developed market investor investing into Africa ex-SA equities (see World and S&P correlations as a proxy), but also from a South African investor’s perspective, where the correlation coefficient is just 0.20. Note that a coefficient of 1 would mean that markets are completely correlated, whereas zero indicates no correlation at all, where correlation explains the strength in relationship between those equity markets shown. The lower the correlation, the weaker the relationship. A developed market investor would thus achieve
more diversification by investing in Africa ex-SA than emerging markets (see correlation of Global Emerging Markets (GEM) versus the World Index or the S&P 500 of 0.81 and 0.70 respectively).

The reasons for investing in Africa ex-SA have been numerous in the recent past. Improving economic conditions have set the continent on an expansion path for the foreseeable future. Furthermore, with inflation expectations declining, this has teed up discussions for lower interest rates across the various geographies. These trends are generally positive for equity markets. Furthermore, smart investors have begun the rotation out of fixed income investments into African equity markets as interest rates expectations trended lower.

While the positive news out of Africa is often predicated on a rising commodity cycle, we believe that the underlying fundamental changes happening in the faster advancing economies are irreversible and should continue to generate significant growth. Infrastructure has been a significant story, while consumerism
and an industrialising middle-class have supported our positive longer-term outlook. Negative headlines from the continent typically focus on the worst issues and incidents that occur, and this has typically resulted in oversold levels across these equity markets. But our view is that investors can continue to realise good returns over the medium term.

To his credit, the (now former) Finance Minister of South Africa, Malusi Gigaba, increased the prudential limits that allow pension funds to invest a portion of their members’ funds outside the country. Specifically, the limit for African investing outside of South Africa was raised from 5% of the pension fund’s assets to 10%. 
For the year ended March 2018, the Ashburton Africa Equity Opportunities Fund has returned 45% against the MSCI Africa ex-SA Index which returned 28%.

Risks of offshore diversification
Investing outside of one’s home market to provide protection from local asset price pressure invariably introduces a further risk: currency risk. The argument can be made, however, that currency risk is already embedded in most portfolios since it is often reflected in bond prices (an input into the fair valuation of equity prices). So, while conversations around inclusivity are incredibly important on the world stage, one must also consider the very real impact of contagion and synchronised global recession. If the global financial crisis taught us anything it is that the world is smaller and more interconnected than it has ever been and while it has made geographic diversification easier, it may also leave it less effective.

Verdict: Is it worth the trouble?
Offshore diversification may not provide the best returns in any one year, as has been evidenced in Africa through the recent cycle, but in the context of lowering risk, diversification is vital in successfully executing a balanced mandate. With rising geopolitical risks and increased volatility across many emerging and developing markets, there is a strong case to be made for placing your eggs in as many baskets as possible.