Currency timing versus the opportunity cost of not investing at all
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By Dean de Nysschen
There are many important considerations when investing offshore, but investors often tend to focus their attention exclusively on the rand. Many are reluctant to invest when the rand has weakened. This article attempts to explain why the benefits of directly investing offshore may potentially outweigh the gains made by trying to time the investment decision.
Timing the externalisation of funds
Upon evaluating the most extreme monthly movements of the exchange rate over the last 20 years (see below), we see a few interesting trends. Firstly, it is unsurprising that the worst month for the local exchange rate was in October 2008 (in the midst of the Global Financial Crisis), where the exchange rate weakened by 18.55%. Six months later the ZAR had strengthened by about 14%, while over a one-year subsequent period (to October 2009), it had strengthened by 20%. This would seem a rational development and may be a good example of why investors tend to avoid externalising when the ZAR has substantially weakened – the belief that the exchange rate should normalise back to its fair value. Interestingly, however, if we look at the average of the ten worst months for the exchange rate (10% depreciation), we see that while the ZAR tends to strengthen by around 2%, six months after the blow-out – over a subsequent one-year period the result is actually a continued depreciation to the tune of 4.5%. Perhaps most importantly, over a subsequent five-year period, the ZAR continued to weaken approximately 38%, and already provides a good reminder that externalisation should be a strategic and long-term decision, rather than one based on shorter-term market movements.
Now, let’s take a closer look at the above historical periods where the ZAR strengthened the most. On a subsequent six-monthly basis, the average movement of the ZAR after severe strengthening was approximately 5% weaker (although this would seem to initially support the idea of waiting for ZAR strength, readers should note that the above data assumes the benefit of hindsight and that in real market conditions, the art of forecasting the most opportune exchange rate entry can be a very challenging endeavour). An interesting endorsement for this, is the fact that subsequent one-year returns, after periods of significant ZAR strength, would - on average – indicate that the exchange rate should proceed to weaken approximately 3%. This is inferior to the average of 4.5% ZAR weakness we observed above, after periods of extreme ZAR weakness (in other words you would have been better off one-year later, even if you had externalised after the most extreme point of ZAR weakness). Although the expectation for the exchange rate to normalise after a blowout is reasonable, history shows that over the shorter term, it could actually go either way. On a longer-term basis, however, the currency will continue to depreciate (as the subsequent five-year returns suggest in both sets of historical returns), regardless of your entry point.
What is the best course of action?
Given the trends outlined above, if an investor expects the ZAR to weaken, then they shouldn’t necessarily be fixated on waiting for the perfect investment entry point. Investors may be tempted to exclusively externalise their money just after the ZAR has strengthened - and the longer-term data above proves that this would obviously be preferential for any investor, if it works out. But what the data also shows us is, regardless of your entry point – a well-planned and longer-term externalisation strategy will reward you over time. Theoretically, the ZAR is a depreciating currency, relative to developed market countries (with lower inflation and lower interest rates) and therefore over a longer period this depreciation trend will continue. The best course of action for investors is therefore to externalise their investment for strategic reasons – according to their unique goals and risk profile – as well as the several benefits these offshore markets can provide (we explore these below in more detail).
Offshore investing is for the long-term investor
An offshore component is an important part of any well-diversified portfolio but should generally be reserved for funds that an investor is willing to invest for the long term, and that are not needed to match ZAR-based expenses.
Let’s conduct a thought exercise, referring to the above historical data once more. We assume that the MSCI World return data could serve as a proxy for externalised investments and provide an indication of the type of returns investors could experience with an improved opportunity set. Furthermore, we then also assume that investors who prefer not to access these markets would invest in the local ALSI Index instead. Interestingly, the data above (reflecting 20 years of data) – on average – implies that the subsequent five-year returns, after periods of both ZAR strength and weakness, would be greater when keeping your assets on local shores (five-year returns on the ALSI are larger than that of the MSCI World for both sets of data). This may seem strange but could potentially be explained by two factors. First, the local ALSI Index has become dominated by ZAR-hedge counters, especially when considering a standard market weighted index (the impact of ZAR-hedge counters is often the reason cited by investors who are of the opinion that externalising is not necessary). Secondly, and perhaps most importantly, twenty years of data includes index returns of the early 2000s. This was a particularly fruitful period for a far less concentrated local stock market, supported by a strong South African economy which was experiencing significant foreign capital inflows at the time and consequently led to bouts of significant ZAR strength. Unfortunately, the economic state of affairs has drastically deteriorated over the last 20 years in SA, and therefore it may be more appropriate to evaluate more recent data below.
The above data applies the exact same methodology used previously, with the only difference being that the last ten years of exchange rate data were used (rather than the last 20 years used before). Here we observe that in both cases (best and worst historical periods for the ZAR), the average five-year subsequent index returns for the MSCI World are significantly higher than for the local ALSI Index. This outperformance provides a valuable reminder that the ability to access a broader opportunity set (which should theoretically provide a greater chance of improved returns) is of critical importance, especially in the face of severe macro-economic uncertainty. When considering the fact that the local market index is ten times more concentrated than the internationally diversified MSCI World – the quality of your opportunity set may in fact be just as important as your entry point. Ultimately, these factors should not be seen as being mutually exclusive – and should be considered holistically, when making your decision to externali
6 Good reasons to invest offshore – irrespective of what the currency movements are
- Access a far greater opportunity set, in terms of geographies, currencies, industries and companies. SA still makes up less than 1% of the global economy, so diversifying offshore is essential. In addition, a struggling local economy and shrinking SA GDP, has in turn influenced the local opportunity set – with the number of locally listed businesses decreasing by approximately 40%, over the last 20 years.
- Obtain portfolio construction benefits – a greater opportunity set brings more opportunity to introduce assets that are uncorrelated (produce returns under different circumstances and at different times). The higher the long-term return you require, the more offshore exposure you need in your portfolio.
- Get exposure to different currencies – Our local currency is not only vulnerable to inflation risk, and significant volatility - but as an emerging market economy can be substantially influenced by the commodity cycle. Exposure to currencies which are less volatile and have less dependence on commodities can assist with risk management.
- Grow your investment to match your liabilities – When externalising funds, you can - to some extent – match your liabilities in your local currency. For example, our petrol price is matched to the oil price in US dollar terms and much of our food is imported. A weakening ZAR will have an impact on these costs, which is unavoidable. By externalising your assets, you also hedge against local inflation, as your currency depreciates based on the inflation differential.
- Avoid sovereign risk – (the risk of a government defaulting on its risk payments) by externalising a portion of your portfolio.
- Obtain tax efficiencies – Realising gains (within a capital gains tax context) is more efficient in time of ZAR weakness, when invested in a direct offshore investment. Although, there are also many efficient ZAR-based vehicles, or “wrappers” that offer tax and estate planning advantages when investing offshore.
Dean de Nysschen is a Research & Investment Analyst at Glacier by Sanlam