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1 FUNDS ON FRIDAY b y G l a c i e r R e s e a r c h 2 7 M a y V o l u m e International Investing for SA Investors The need to feed: A case for Feeder funds Written by: Luke McMahon Junior Research & Investment Analyst at Glacier by Sanlam Historical studies have produced evidence that a sound international investment strategy offers significant benefits to a portfolio by reducing volatility, thereby reducing risk. It also mitigates other risks such as currency depreciation risk and country risk which are inherent in a portfolio which is only comprised of assets in a single country. Enhanced returns are also demonstrated to be a beneficial concomitant of incorporating international exposure into an investment portfolio. Over the last couple of decades investors have developed an acute awareness to these benefits of international investing. This article will aim to highlight the growing trend of international investing in SA and the potential benefits offshore investing could provide to investors who may not have any foreign exposure in their portfolio, or for those who do not have a larger focus on the offshore component within their existing portfolio. International Diversification The benefits of diversification was first pioneered by the earlier work of Markowitz (1952) in determining optimal portfolio selection and became the foundation of Modern Portfolio Theory (MPT). The theory was not limited to specific asset classes but was mostly used to analyse diversification effects domestically in one country. Subsequently, studies over the last few decades were conducted whereby the benefits of international diversification came to the fore. According to Oldier & Solnik (1993) it was repeatedly demonstrated that international diversification reduces the volatility, i.e. risk of a loss in a portfolio. Investing abroad provides a F U N D S O N F R I D A Y 2 7 M a y Page 1

2 way to achieve this diversification. The traditional measure of volatility is standard deviation. To illustrate this, the following table illustrates the riskiest asset class, namely stocks, of various nations in their local base currency. Each countries main stock market was used as a proxy and standard deviations (%) were calculated over a 10 year period. The lower the percentage the lower the perceived risk of the investment. Figure 1. Volatility of local stock markets vs global markets Source. Morningstar Direct It is clear to see that global markets have a lower standard deviation (volatility) when compared to local markets. Therefore, it suffices to say that incorporating global stock markets in a local stock portfolio will reduce volatility, i.e. risk. Optimal portfolio: Local vs International portfolio The next question to address is how much of the portfolio should be invested in international assets. The optimal proportion of weights in a portfolio is derived from the optimal mean-variance portfolio (Camilleri, Iqbal & Wang, 2005, p. 4). To demonstrate the impact of incorporating foreign assets in a local South African (SA) portfolio, a study conducted by Bradfield & Munro (2015, p. 413) whereby they performed a mean-variance efficient frontier analysis of domestic and foreign assets in a proxy portfolio. The proxy portfolio asset classes included domestic equities (proxied by the All Share Index), domestic bonds (proxied by the All Bond Index), domestic property (proxied by Property Unit Trust Index, Property Loan Stock Index and Listed Property Index) and foreign assets comprising foreign equities (proxied by the MSCI Global Equity Index), foreign bonds (proxied by JP Morgan World Bond Index) and foreign cash (proxied by US 3-month treasury bills). Monthly total return data for each asset class was used for a 40 year period ( ) to account for regime and structural changes in the market and establish strategic long-term insights (Bradfield & Munro, 2015, p. 415). The mean-variance efficient frontier analysis yielded the following result in terms of where the non-foreign asset frontier is positioned as opposed to a foreign asset frontier, as depicted below. Page 2

3 Billions Figure 2. Source. Bradfield & Munro (2015) It is quite evident from the figure above that the inclusion of foreign assets significantly shifts the efficient frontier to the left, i.e. the volatility (risk) is reduced and shifts the frontier upward, i.e. returns are enhanced. This particular study yielded an optimal foreign asset allocation weighting of 41% in the optimal mean-variance portfolio. Increased appetite of SA Investors toward international investing From the above discussion it is evident to see why there is a growing interest from SA investors towards international investing. The benefits of holding foreign assets in a local investor s portfolio are undeniable and warrant inclusion. It is therefore plausible to infer that as a result of the benefits afforded through international investing that there have been increased investment flows to Non-SA assets by SA investors, as graphically depicted below Off shore versus SA net flows Q Q Q Q Q Q Q Q Q Q Q Q4 Non_SA South African Figure 3. Source. Sanlam Investment Management Page 3

4 Millions International investing for SA investors With increased systemic risk in the local SA economy thanks to political debacles, government inefficiencies, volatile market movements, sovereign credit downgrades, devastating drought conditions and significant rand depreciation, offshore investing remains high on the agenda for many SA investors (Cairns, 2015). One way of mitigating these systemic risks is by investing assets abroad and diversifying exposure to a single country. Academically the rationale behind this is compelling and investment industry professionals encourage an investment strategy which has a serious focus on international investing over the long term (Cairns, 2015; Paine, 2016). For SA investors there are broadly two options available to invest abroad. The first option entails investing in hard currency, initiated by first opening and transferring funds into an international bank account. This can be done via local investment firms who have an offshore platform or through international banks who have a local presence in SA. This method of international investing has increased substantially as demonstrated in figure 4 below, displaying total inflows over the last 5 years via a local Linked-Investment Service Provider (LISP), offering an offshore platform. Once this step is in place an investor can immediately start investing in foreign assets in the appropriate foreign currency, either through a broker or directly via the offshore platform. This ensures that currency risk is reduced as investments will not be subject to currency fluctuations and onerous foreign exchange conversions back to local rands. However, there are exchange control considerations stipulated by SARS which preclude an investor from investing as much as they want under this option. Currently, an SA investor can discretionarily invest R1 million p.a. in foreign exchange investments without requiring SARS tax clearance. Thereafter a further R10 million p.a. foreign exchange control is in place which requires SARS tax clearance (Paine, 2016) Figure 4. Total inflows in USD (cumulative) Source. Glacier International Page 4

5 Billions The second option is to invest in rand-denominated offshore funds. These funds are priced in rands but the capital is invested offshore which gives SA investors the global diversification and foreign currency exposure to enhance their investments (Paine, 2016). The additional benefit that this form of investing provides is that no tax clearance is required from SARS as the funds are invested in rands and paid out in rands in SA upon disinvestment. Hence, administratively this option is simple and easy for SA investors to access global investment assets. This form of international investing has become quite popular amongst SA retail investors as demonstrated below, and is formally referred to as a Master-Feeder fund structure. 10 Net flows to ZAR denominated non-sa Funds Figure Q Q Q Q Q Q Q Q4 Source. Sanlam Investment Management Master-Feeder fund structure According to Stadt (2014, p.1), a master-feeder fund is a two-tiered investment structure in which investors invest their capital in a feeder fund, which in turn invests its assets in a master fund managed by the same investment manager. Ultimately, the master fund is the entity that actually invests in the market. In essence the Master-feeder structure allows investors from different geographies to invest side by side in a particular offshore fund without being affected in anyway by the adjacent investor s investment and tax situation. Feeder funds under the same master fund can differ in their investor types, investment minimums, fee structure, net asset values, and other operational features (Stadt, 2014, p. 2). Page 5

6 Eg. Nedgroup Global Equity USD (Offshore fund) Eg. Nedgroup Global Equity Feeder (ZAR) Local SA Investors Offshore Investors Figure 6. (Adapted) Source. A master fund is its own legal entity, and is typically an offshore corporation, incorporated in a tax-neutral offshore jurisdiction, such as the Cayman Islands or Bermuda (Vasilopoulos & Abrat, 2004). The master fund is unrestricted in its choice of companies either by size or industry or in terms of the geographical makeup of the portfolio. The general way in which the structure works is depicted below. Figure 7. Source. Benefits of using Feeder Funds The benefit of this structure is that it doesn t limit the investing fund (Master) to one type of investor. The structure is used to enhance the critical mass of tradable assets by accumulating funds from feeder funds domiciled in multiple geographies. This drives operational efficiencies within the master fund, substantially increasing liquidity and reduces costs. These are then passed on to the feeder funds and ultimately the end investor. The Master-feeder structure also enables investors to achieve greater access to a broader pool of capital and talent in terms of Page 6

7 Trillions international asset management firms through locally recognised vehicles. As an example, SA investors can gain access to offshore markets and also offshore asset manager expertise and capabilities in the US through a SA domiciled feeder fund, with the added benefit of reduced costs and greater efficiencies. This investment structure also allows local investors greater access to world capital markets. The US alone comprises more than 50% of the world s free-float stock market capitalisation, followed by countries such as China, Japan and the United Kingdom. South Africa accounts for approximately only 1.50% of total world market capitalisation. SA vs World - Market Capitalisation US$ South Africa (ZAF) Market capitalization of listed domestic companies (current US$) World (WLD) Market capitalization of listed domestic companies (current US$) Figure 8. Source. data.worldbank.org Lastly, legal segregation between the Master and Feeder funds allows them to invest in assets other than the master fund. Under particular jurisdictions, such as the European Union, which falls under the Undertakings for the Collective Investment in Transferable Securities (UCITS) Directive, the UCITS IV directive allows feeder funds to hold 15% of their assets in either cash or in derivative instruments for hedging purposes. This allows for added diversification of risk within the fund. Conclusion In order to maximise investment potential it may be prudent for investors to adopt an approach whereby they think globally, but act locally. Being concentrated and over exposed to just one market is rarely going to produce the optimal risk-reward results that one would hope for in an investment. Empirical evidence has shown that a long-term, well-diversified international portfolio Page 7

8 can help mitigate unnecessary risk and at the same time offer opportunities for enhanced returns. This has been underpinned by the phenomena that a growing number of SA investors are engaging in offshore investing. This paper mentioned two distinct options namely the utilisation of foreign hard currency allowance via an offshore platform and investing in rand-denominated offshore feeder funds. Moreover, the first alternative provides protection against currency and sovereign risk, while the second alternative provides a tax and cost-efficient way of gaining international exposure. Each alternative harbours considerable benefits to obtaining a desired risk-return trade-off. Page 8

9 References: Bradfield, D.J. & Munro, B. (2015) Raising the Bar on the foreign portfolio 25 per cent: Strategic implications for South African investors. South African Journal of Economic and Management Sciences, 2015, vol. 3, pp Web: - accessed: 12/03/2016 Cairns, P. (2015) - What s the best way to invest offshore? Moneyweb, February, Web: - accessed: 10/03/2016 Camilleri, D., Iqbal, M. & Wang, T. S. (2005) Optimal asset allocation and risk management. Asian Review of Accounting, Vol. 13 (1), 2005, pp Web: - accessed: 10/03/2016 Koegelenberg, F. J. (2012) Optimal Asset allocation for South African pension funds under the revised Regulation 28. Stellenbosch University, Department of Statistics and Actuarial Science. Markowitz, H. M. (1952) Portfolio Selection. The Journal of Finance, Vol. 7 (1), Mar. 1952, pp Web: - accessed: 14/03/2016 Merriman, P. (2015) - International investing offers a world of opportunity at a relatively low cost. Marketwatch, Apr Web: accessed: 10/03/2016 Moyle, M. (2011) Diversify and reduce risk with offshore investments. Web: - accessed: 12/03/2016 Munro, B. & Swartz, J. (2006) Asset Allocation - How much abroad? A strategic and active perspective. Cadiz. Oldier, P. & Solnik, B. (1993) Lessons for International Asset Allocation. Financial Analysts Journal, Vol. 49 (2), Mar-Apr 1993, pp Published, CFA Institute. Web: - accessed: 10/03/2016 Page 9

10 Paine, C. (2016) - Investing offshore as a South African Why, How & Where? Fin24, January, Web: - accessed: 11/03/2016 Solnik, B. & Noetzlin, B. (1982) Optimal international asset allocation. Journal of Portfolio Management, Vol. 9 (1), 1982, pp Stadt, K. (2014) Understanding Master Feeder Accounting. Advent Partner. Web: aster_feeder_publish.pdf - accessed: 11/03/2016 Vasilopoulos, E. & Abrat, K. (2004) The Benefits of Master-Feeder Fund Structures for Asian-based Hedge Fund Managers. Sidley Austin Brown & Wood (Hong Kong). Web: er_fund_structures_for_asian_based_hedge_fund_managers - accessed: 13/03/2016 Page 10