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Offshore Investments
Tuesday, May 1, 2007
No commodity cycle call

How well do active equity managers protect South Africans from the commodity cycle? And what other options do investors have, asks David Crosoer of Glacier by Sanlam?

“South African investors remain nervous of going offshore, and continue to rely on local equity managers to protect them from a melt-down in commodity prices,” he says. “Is this the best strategy to adopt to avoid the pitfalls of investing in an economy strongly at the mercy of the global commodity cycle?”
The South African equity market outperforms international markets when commodity prices are strong. Offshore developed markets provide diversification away from resource shares, because these make up much less of their equity market indices (typically under 10% — the exception is the UK). As sellers of commodities (along with other emerging economies) the prices at which commodities are traded is the fundamental differentiator of South Africa’s performance relative to developed economies (who are buyers of commodities). This has benefited the local equity market over the past six years (the Economist Commodity Index has almost doubled since 2000). But this hurt performance over the previous twenty years where the index actually declined.
“The first chart illustrates just how closely our fortunes are tied to the performance of commodities,” notes Mr Crosoer. The dotted line shows relative performance of the All Share to the S&P500 (both in US$) – an increase represents outperformance of the All Share. The solid line is the price of gold in real terms – a proxy for the price of commodities.

The chart clearly illustrates that local is lekker when gold (and other commodity) prices are strong. The All Share has outperformed the S&P500 since 2000, a period when gold has been increasing in real terms too. This reversed a prolonged period of stagnating commodity prices and relative underperformance of the SA market to the US market.
South African equity managers generally have not tried to time the commodity cycle, but have been consistently underweight of the resource sector in the local market. Fund managers have an inherent bias towards the more predictable income streams of financial and industrial stocks, and have demonstrated a strong aversion to tying the performance of their funds to the commodity cycle by not investing in resource stocks. Such a strategy (overweight financials and industrials) was a one way winning bet prior to 2000 when commodity prices were in a long-term bear market, but has had a more erratic success rate since.
The second chart tracks the twelve month outperformance of the All Share by Financial and Industrial shares (solid line) against the outperformance of the All Share by the average equity fund (dotted line). It demonstrates how the average active equity manager outperforms the All Share Index when Financial and Industrial Shares outperform the All Share Index.

Selecting an active manager is not straightforward. There is always the possibility that the investor will select a sub-average manager, or that the manager will blow-up spectacularly. And selecting the average manager is not an investable strategy as the average manager will not be the same manager every year.
Active management also does not come cheap. The average equity fund charges 1.43% per year. Investors consequently appear willing to pay more than 1% more than the cheapest index fund (the Gryphon All Share Tracker has an annual management fee of 0.34%) to diversify away from the commodity cycle.
Offshore markets provide a far wider universe of non-resource stocks to choose from than our local market. The table shows the long-term standard deviation of the local market with the US market (both in rands). “We’ve deliberately focused on risk rather than return,” explains Mr Crosoer, “because the decision to go offshore should be about risk management, rather than trying to pick winners. From the table one can see that over the very long-term the US market has been less volatile in rand terms than the South African market. Column 4 in the table shows that a 50:50 combination of local and offshore indices tends to have a lower volatility than the individual offshore and local markets.

“Investors have been reluctant to go offshore as the local market has performed so strongly,” he notes. “But the decision to go offshore should not be based on making a call on the commodity cycle or whether foreign or local markets will outperform.
“Rather, it is an essential step in constructing a diversified portfolio that protects investors against the inherent risks in commodity cycles and local active equity managers. Advisors need not focus solely on picking active fund managers to add value to their clients, but can use offshore funds to diversify away from the commodity cycle, and make use of local index funds to minimise costs and reduce fund manager risk,” he says.

Copyright © Insurance Times and Investments® Vol:20.4 1st May, 2007
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