It’s not so simple
The announcement that Regulation 28 will be reformed to allow an increase in the foreign allocation to 45% in total (the 10% separate allocation for Africa has fallen away) has made waves in the investment industry in South Africa. For years, investors have been waiting for the opportunity to “go max” in global to offset the risk of the ZAR. But is it a case of be careful what you wish for? As it might just happen.
In a nutshell, more global equity in a domestic-heavy equity fund widens the opportunity set and provides diversification due to the geographic and sector diversification that the globe provides. It also provides exposure to global franchises which provide the Quality and Growth style exposure that a South African-only portfolio cannot provide, given South Africa’s concentration to cyclicality and value. But, it’s not all roses; higher global exposure does come with additional risks with the probability of higher drawdowns and additional currency risk that needs to be effectively managed.
It’s all in the detail
Our detailed data analysis and back tests have shown that while we all fear the volatility of the ZAR, increasing the global proportion in portfolios ironically increases volatility in performance and the actual drawdowns increase. At Sentio, we believe the inclusion of global in higher proportions is more about diversification and a wider frontier of views. This has implications for how the overall portfolio is managed, especially the portfolio construction and global factor exposure. These cannot just be managed “by default” and in our view, proactive management of sector, factor and asset allocation become paramount to managing the larger drawdowns and ensuring that the diversification we seek is realised.
“Benign neglect” is not an effective global strategy
An aggressive asset allocation strategy combined with a high conviction stock selection on their own will not be optimal for investors. This is because it relies on correlation structures being stable and ignores the increased reflexivity and dynamic structure of markets. We believe that managers need to have defined and deliberate asset, sector and factor allocation strategies to prevent the dilution of returns through poor factor and sector allocation. At Sentio, our use of machine learning and artificial intelligence (AI) in risk management, portfolio construction and stock selection means that we take deliberate risks using a scientific and globally competitive process.
Established global managers or South African fund managers?
The default position for many asset owners is to hand the assets over to large global houses. However, we argue that this misses some important interplays that affect portfolio stability and volatility. A portfolio that is scientifically managed by a South African manager to take account of the cross-section of higher order risks will result in better outcomes. It also adds nimbleness to the decision-making, which is essential in volatile environments. However, there are caveats.
The South African manager needs to have a credible and defined global process that is differentiated on alpha generation. The big question is: how are you able to generate alpha ideas and does that rubber hit the road in the final portfolio construction?
We believe our investment team can compete with the large global players using our process and technology on two fronts: finding alpha in a targeted approach and constructing risk-appropriate portfolios for South African clients. Our global process has been tested and honed over the last 15 years and the use of technology allows us to effectively tailor portfolios.
