Lately, the debate about offshore investing has become a hot topic again. It seems like every time there is a hint of bad news in South Africa, the floodgates open, and money pours out of our country.

If it is not corruption, it is politics, Eskom, or other state-owned enterprises failing. Now we have the National Health Insurance (NHI) Bill signed into law, and our doctors and medical personnel are threatening to leave our shores.

Many investors are desperately looking to get more offshore exposure across all investments. This, in itself, is not the problem. The problem is at what cost, and does it fit into your investment strategy?

As South Africans, we should be used to adversity by now. We should also give ourselves credit for being survivors and that our businesses are not fence-sitters that wait for things to happen. They jump in and take control. This is clear if we look at the progress electricity supply has made (no thanks to Eskom), and the same will happen where other services are failing. 

The government has realised the importance of collaboration with the private industry for SA’s survival. Due to financial limitations, the government has opened its doors to the private sector, inviting them to contribute to repairing what has been broken. This is a beacon of hope and a potential catalyst for the much-needed revival of our economy. Hopefully, the same trend will continue when the NHI eventually comes into play.

Now, let’s connect the dots between offshore investing and the South African context. I want to clarify that I am not a blind advocate for South African investments. I firmly believe in the potential and benefits of offshore investing. However, I also want to caution investors to tread carefully to avoid being on the wrong side of the curve when SA’s situation improves. More importantly, be very careful not to take funds offshore aggressively while the rand is grossly undervalued.

Let’s delve into some key points:

The inverse effect of rand volatility has a profound opposite effect on pre-retirement and post-retirement investing when offshore exposure is relevant.

Let us agree. Rand fluctuations substantially increase offshore investment volatility when measured in rands, which in turn affects the sequence of returns within investments.

The sequence of returns has a different effect at three levels: 

1. When making a capital investment for a specified fixed term without making additional contributions or withdrawals, the sequence of returns does not affect the outcome, and the timing and method of achieving returns are unimportant. Long-term returns will aggregate to the same value regardless of the sequence in which they are earned. Rand volatility does not impact the investment value at the end of the term. If you invested when the rand was undervalued to the point that investment returns were lower than the rate of rand recovery, that will lead to a loss, but that has nothing to do with rand volatility. That is plainly investing when the rand was too cheap or dis-investing too soon. (That is why it is important to measure returns of direct offshore investments in hard currency and not the rand.)

2. While accumulating funds via regular monthly contributions, a more favourable outcome is achieved when investing when the rand is volatile and moves to a point of strength when you retire. As the rand fluctuates (and we know that long-term it will devalue), your contribution will buy more or fewer units every month depending on the exchange rate at the time. We refer to this as rand-cost averaging. During phases where the rand strengthens, more units will be acquired and vice versa. If we analyse periods when the rand has historically strengthened, there has been a tendency for the SA market to outperform its global peers simultaneously. This makes sense because the rand will only strengthen if demand for the rand increases, and demand will only increase if foreigners invest in our stocks and/or bonds. During these periods, you encountered a triple whammy where the rand increased, SA markets increased, and global markets decreased. If you draw income against a portfolio that encounters this “perfect storm”, you are going to be in for a rough ride for many years to come.

3. When drawing an income from an investment, volatility is your enemy, and a different approach must be adopted. In fact, a strategy opposite to that of accumulating funds is needed. Where volatility counts in your favour when investing offshore monthly (accumulating more units as the rand strengthens), as explained above, volatility destroys wealth when you draw an income from an offshore portfolio and the rand strengthens because you have to sell more units to retain the same income. The higher your drawing, the more units must be sold. This is one time that timing the market (or rather timing the currency) is vitally important. 

Let’s look at the graph below, and hopefully, my point will be made more definitively.

The graph below depicts the movements of the rand/dollar exchange rate from 2000 to the present. It shows four significant recovery periods during which the rand strengthened considerably and maintained this level for a substantial period of time.

Note: A downward arrow indicates the rand strengthening.

I would like to remind you that to break even, a loss of 30% requires a profit of 43% to break even while a loss of 54% requires a profit of 117% to break even. Add to this a drawdown % and a market loss as indicated, and you will realise the potential problem.

The graph also indicates prolonged periods before achieving the same “weakness levels” again. Periods of more than five years are not uncommon. After the 2001 recovery, it took 14 years to achieve the same level again.

What is important to note is that over the past 23 years, the rand has been in a recovery phase for eight years. This means that people who retired at the peak of rand weakness and the recovery period thereafter experienced capital losses on their offshore investments that were aggravated by their drawings. The negative effect of the sequence of returns was in full play.

Those investors who made regular contributions to their offshore investments during these periods experienced the benefit of the sequence of returns by acquiring more units during the next rand depreciation period, and they would have been rewarded handsomely.

We are currently experiencing a rand recovery of 8% over the last year and 6% over the last month. I am not sure where this will end, but the rand is currently considered to be undervalued, and the SA market and markets outside the S&P 500 seem cheap. The UK market, as are some other counters, is trading at a 40% discount to the US market. 

Over the past decade, the “offshore story” was mainly a US tech story. The rest of the world markets and the rest of the US market performed mediocre and some disappointed. The challenge is to identify the next sectors and niches that will carry us through the next decade. 

We live in a country filled with turmoil and challenges, but it remains a great country. Remember, the “rand story” is not just a South African story. We are part of an emerging market (EM) basket that the rest of the world decides to invest in or disinvest. We just go along for the ride.

Over the last year, the rand was the fifth-best-performing EM currency. Over the past decade, the world was in “risk-off” mode. Sit tight for when they decide to flip the “risk on” switch. Hopefully, our infrastructure and political issues will be on track to better news. If it is, we will be in for quite a ride, but always retain a healthy chunk of well-priced offshore investments. 

Happy voting!