Almost a year ago, National Treasury surprised the investment community by announcing several amendments to Regulation 28, the key change being to allow exposure to foreign assets up to a maximum of 45%.
The changes are particularly relevant for multi-asset portfolios, where an increase in the potential allocation to a wider array of domestic and global assets has significant consequences.
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There is a growing narrative that additional flexibility automatically boosts returns while dampening risk. However, given the expanded range of opportunities and the impact of foreign exchange movements, the variability of returns naturally widens.
These new investment options also became available when the end of cheap money created financial upheaval.
As a result, last year was incredibly challenging, especially as relationships and trends that investors have relied on broke down or reversed.
This begs the question, do we see a return to the old trends, where our positive view on global equities largely benefited performance, or is a new investment environment emerging?
Figure 1: Will global equities continue to deliver long-term growth?
Source: Ninety One, as at 31 December 2022.
The real volatility risk
Volatility increases the possibility of poor investment decisions, particularly in the short term – but can create more opportunities to buy or rebalance assets at lower prices.
Given the increased opportunity set, it is therefore critical to assess what remains optimal for asset allocation and selection.
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Identifying investment opportunities
Let’s consider three areas of new interest:
Infrastructure
Infrastructure assets benefit from a combination of defensive fundamentals and structural growth drivers, with the ability to generate inflation-protected income. They also typically have a low correlation with other assets, low sensitivity to the economic cycle and sustainable cash flows.
Infrastructure also has relevance for South Africa, given the deterioration of government’s fiscal position and effectiveness, and the lack of funding within state-owned enterprises.
But infrastructure investments carry two significant investment risks: they are illiquid and may not be saleable at the time an investor plans to exit. They are also typically highly leveraged, resulting in a heavy interest burden.
Global credit
From a portfolio construction perspective, global credit provides more liquidity and diversification benefits than domestic credit. However, dismal yields have diminished the appeal of global credit as an asset class. Now, as yields have moved up and spreads widened, the asset class has started to garner more interest.
Unfortunately, central banks have severely distorted certain markets, and it will take time for those distortions to work through the system. While valuations may appear compelling, volatility in this market remains elevated.
Private equity
The amendments also allow Regulation 28-compliant portfolios to allocate assets to private markets like private equity funds, up to a limit of 15%. However, private equity investments involve a higher degree of risk and may result in partial or total loss of capital.
By their nature, alternative investments are complex, speculative investment vehicles, and the lock-up period of private equity makes it illiquid.
Given the market disruption, what is our view on more traditional asset classes that have been overlooked for some time?
Global cash
Global central banks raised rates aggressively in 2022, pushing borrowing costs to their highest levels since 2007 to fight inflation.
Despite this, most opportunities still do not provide a real return, but currency diversification is valuable and global cash can provide a defensive ballast in volatile periods.
Global bonds
While yields have risen in line with central bank measures, we believe they are not compelling enough to make a significant allocation.
Global property
Global property does not typically provide enough portfolio diversification benefits, and we find better risk-adjusted opportunities within other global asset classes, such as global equities.
So, what about emerging market (EM) opportunities beyond SA?
In our view, EM opportunities outside South Africa are too highly correlated with domestic opportunities, given the nature and tradability of our market, and thus fail to deliver attractive diversification and risk-adjusted returns.
Will the US enter recession? What will the rand do in the next six months? While forecasting is easy and being right is reassuring, it can be risky as it may become something you do to justify how you want the world to work, rather than analysing how it actually works.
Accurately predicting what is going to happen, particularly in the short term, is virtually impossible to repeat consistently.
Most macro events are infinitely more complex than we assume, and with forecasts accountability is lost.
But if it’s so difficult to forecast accurately, how does one construct portfolios? While remaining cognisant of short-term influences, robust models form the fundamental basis of providing a firm foundation.
Based on a five-year forward-looking view, we invest in companies where we have developed a deep understanding of their outlook through fundamental analysis. The businesses we own tend to be less reliant on macro forecasts and the economic cycle, thus providing a greater degree of certainty of the outcome.
Maintaining a disciplined approach to asset allocation through the cycle is crucial to generating long-term wealth. But the allocation is not static, and we tilt the portfolio towards defense, growth or cyclicality based on our views.
Figure 2: After a tough year, the opportunity set has improved
January 2022 vs. January 2023 – expected 5-year returns
Source: Ninety One. * For illustrative purposes only. This is not the return of the Fund. Five-year expected asset class returns are based on disclosed reasonable assumptions and are not a reliable indicator of future results.
Conserve and compound
Real returns are on offer within available investment options, which have not changed dramatically despite regulation amendments and a shake-up of markets. Greater flexibility increases complexity and will not necessarily result in better outcomes for investors, but skilful managers with global expertise can benefit.
Let time put the odds in your favour as compounding only works if you give an asset time to grow.
Clyde Rossouw, co-head of quality at Ninety One.
