The home bias dilemma - how do you determine the right level of offshore exposure?

By Jannie Leach

A question that is debated across many markets around the world is: What percentage of my portfolio should be invested offshore?

This is especially the case during times of political or economic duress when investors seek refuge in markets outside of their home countries. Unfortunately, this is often the wrong time to ask the offshore allocation question as it is highly likely that their home currency and markets had significantly declined by the time they started panicking. As an example, in 2001 the South African rand weakened from around R8 to over R12 to the US dollar. Many South African investors panicked and move their assets offshore. Over the next decade the rand strengthened by over 5% per annum, wiping out any returns they may have received from their offshore investment holdings.

One of the major problems with the offshore allocation question is that it is asked from the perspective of an investor with a home bias. In most countries around the world, investors have an overweight to their domestic market's equities and bonds relative to a global market cap index. This overweight is described as having a home bias. Over the past few decades the case for a home bias has become less convincing as global investment vehicles have become more accessible to investors and offer greater diversification. Incorporating global investments into the strategic asset allocation of an investor should also reduce the potential investor behaviour penalty often incurred when money is invested offshore after bad news.  

The chart below shows the home biases within pension funds from different countries across the world. Australia has one of the biggest home biases at 26 times its FTSE All World Index weighting. South Africa, on the other hand, is 129 times its index weighting! This clearly poses significant concentration risks relative to investors from other countries.



In South Africa we have already seen a big move towards offshore investing in the discretionary space as accessibility has become easier through direct UCITS funds, local and offshore platforms and offshore rand denominated feeder funds. We have also seen increased usage of offshore feeder funds in living annuities which don't have to comply with the offshore limits of Regulation 28.

If we see further relaxations of exchange controls over the next decade, this trend will likely include a much broader spectrum of South African investors, not just High Net Worth (HNW) individuals. It will also have an impact on how financial planning is done from cradle-to-grave and how global investing is introduced into an investor's portfolio. These changes will also have an impact on risk profiles multi-asset unit trusts that generally comply with Regulation 28 and which caters for compulsory and discretionary investments.

The Global Market Portfolio

In order to untangle the home bias dilemma, one needs to change the investors perspective from a home biased portfolio to the most diversified "unbiased" portfolio, namely the Global multi-asset Market Portfolio. The global market portfolio (GMP) represents the views of all market participants across the globe in respect to the values of each asset class. This portfolio therefore represents the only truly "passive" or market portfolio and is therefore the one true benchmark for all investors' strategic asset allocation weightings. The chart below illustrates how the GMP's asset class weightings have changed over the nearly 60-year period.
 

The GMP average asset allocation over the past 60 years has been around 51% in equity, 3% property, 44% bonds (government and credit) and 2% commodities. The Nedgroup Investments Core Global Fund (and Feeder) which has a combined equity and property allocation of 75% can be viewed as a higher equity version of the GMP. The Nedgroup Investments Core Global Fund could in theory be used by any pension fund investor across the world as it has no overweight to any home country. It is therefore a useful starting point to evaluate the impact of home biases in achieving investor's return objectives.

Unpacking the home bias dilemma for a South African investor

In order to deal with the home bias dilemma for a South African investor, we have modelled balanced funds using different combinations of the Nedgroup Investments Core Diversified Fund and the Nedgroup Investments Core Global Feeder Fund. This allowed us to study the trade-offs between broader diversification and increased volatility due to the currency. We also studied the tax benefits within compulsory and tax-free investment structures for funds with different home biases. These factors are important as retirement savings must match the investor's future Rand based liabilities. 

The table below summarises the result for four portfolios covering: no home bias, 35% (half of Reg 28), 50% and 70% (Reg 28) home biases. One can see how the concentration risk increases proportionate to the home biases as measure by the first four rows. The two combined portfolios illustrate how higher offshore allocations within a balanced fund can reduce these concentration risks.

The second table looks at the impact of taxes on discretionary and compulsory investments. Compulsory investments include retirement vehicles such as employer pension funds, retirement annuities and preservation funds. Tax-free investments would deliver the same returns as compulsory investments. One can see "home" assets benefit more from the tax savings within compulsory structures. The four portfolios deliver similar returns for discretionary investments.

The charts on the following page illustrate the impact of home biases on the range of returns over different rolling periods. A portfolio with no home bias has the widest range of returns as measured by the difference between the 5th and 90th percentile rolling returns. It is interesting to note that a portfolio with a 50% home bias has a narrower range of returns over rolling 1-year periods - illustrating some of the diversification benefits. It makes this portfolio suitable to investments where income is withdrawn, for example within Living Annuities.      

This research indicates that if legislation allows for higher offshore allocations that one could easily reduce the home bias to 50% or even 35% and still have portfolios that have reasonable range of returns over rolling 5-year periods. Increasing the offshore allowance will of course lead to greater variation in relative performance between funds in a given Asisa category.

The implication for the Nedgroup Investments Core Diversified and the Nedgroup Investments Core Accelerated Funds is that, if allowed, we would take the offshore to at least 50%, as at that level we would be able to cater for most investors' needs. Under the current dispensation we have increased the offshore allocations to maximum for both funds during December 2020.  The Nedgroup Investments Core Guarded Fund's offshore has also been increased to a level in line with the fund's shorter minimum investment horizon.

While the range of the returns over the different rolling periods don't differ too much across the three portfolios with home biases (35%, 50% and 70%), the different home bias allocations can make material difference in annual returns over the short term. We have illustrated this in the chart below where we compare the annual returns relative to the 70% home bias portfolio.

How can you practically reduce your home bias?

The offshore exposure in your retirement savings is currently capped at 30%. This means that if you want to increase your offshore allocation for long term savings to 50% or 65% you need to use additional investment vehicles. A tax-free investment (TFI) would be your first port of call as it also offers tax savings. Retirement and TFI vehicles unfortunately have annual contributions limits:

  • Retirement funds - 27.5% of gross annual salary capped to maximum amount of R350 000 (or R29 167 per month).
  • TFI - R36 000 per annum or R3 000 per month

Any additional offshore exposure can be obtained by using unit trusts without investment wrappers (discretionary). The table below illustrates how one can target a 50% home bias in monthly savings contributions using a combination of the Nedgroup Investments Core Diversified Fund (or Core Accelerated Fund) with the Nedgroup Investments Core Global Feeder Fund within retirement vehicles, TFI and discretionary Unit trust. 


One can see how once the TFI limits have been reached additional investments are made through discretionary unit trusts. The final example illustrates how one would utilise the tax savings on home biased (Reg 28) investments and shift the offshore exposure to discretionary unit trust.

Home biases in pension portfolios is a global phenomenon and can be reduces using a variety of investments options. Reducing your home bias has a definite diversification value but one should not discount the impact of tax savings on long term investments. The home bias debate is ultimately about balancing concentration risk with matching future liabilities in your home country. It will be different for everyone depending on their circumstances and future liabilities. The home bias within a regulation 28 portfolio is however higher than what is required by most investors. Aiming for a 50% home bias should reduce concentration risk while still retaining some of the tax savings advantages on home assets.