I don’t write as often as I would like to, but this has been a topic that has been on my mind for a few months, so I have finally made time to put my thoughts down. I hope you enjoy it.
SPOILER ALERT!! Increasing offshore allocations will not significantly improve your retirement investment outcomes.
Previously, you were only able to invest a maximum of 25% of your Reg. 28 portfolio offshore, with an additional 10% investment allocation into Africa-based investments. This has since been adjusted to a 45% offshore limit, with the Africa requirement removed. This has led to many applauding the move with leading industry figures concluding that this would improve performance of regulation 28 investments. But will it?
I am of the view that any investment that applies limits is a structurally flawed investment. The details that are often ignored are the way in which investment allocations are made and reported. This is not unique to regulation 28 funds. It also applies to other collective investments like unit trusts and exchange traded funds (ETFs). A quick squeeze through a disclosure document will give you a view of the portfolio breakdown. Have you ever questioned or dug into what this means?
A few things that come to mind:
If I invest R100, does it mean R10.36 will be allocated to Anglo American?
If this is the existing weights, and share prices move daily, what are the actual allocations of the money already invested in the portfolio?
Although most funds are rebalanced quarterly, does this affect the investment allocation within the quarter or is all money invested in the same proportions given the fluctuations in prices?
Below is the asset class breakdown of one of the largest reg.28 funds:
The total foreign allocation is 37.06%.
Does this mean 37.06% of new contributions will be allocated to offshore assets?
How does the contribution allocation compare to the current value?
Another example is the ‘special rebalancing’ of the Nasdaq100. This was a result of the Top 5 stocks making up more than 43% of the index which was deemed ‘more top-heavy and unbalanced than preferred’ by the powers that be. Preferred by who? Personally, I was disappointed by this as the index was not constructed with a capped allocation in mind. This has led me to question if the creators aren’t playing God by interfering with weights. I am all for letting things run, regardless of how pleasant or unpleasant the outcome may be.
I have applied the same concept to my portfolio. These are the portfolio weights according to purchase amounts and the current values:
As you can see, the holdings change according to how you choose to report.
Back to Regulation 28 funds, what do you think a 45% allocation to foreign investment looks like?
Allocate 45% to foreign equity, and let that run freely? Or make sure the current value of the foreign allocation never exceeds 45%?
Here is something to consider: using the Top 40 as a proxy for local investments, and the S&P500 for foreign investments, what would R10 000 invested a year ago, look like today?
Suppose we allocate R5 500 to the Top 40 and R4 500 to the S&P500 as per limits, you end up with the following outcome:
After 1 year, the offshore allocation will be on 48% as per the current values breakdown.
What will happen next is that the investor holding this portfolio would receive a notice that their investment has exceeded limits, and they need to rebalance their portfolio to bring it back to within the prescribed limits.
Rebalancing this portfolio can be done in 2 ways:
Sell some shares in the S&P500 and purchase more shares in the Top40.
Allocate more of the new contributions to the Top40 than to the S&P500
You are selling a performing asset, to purchase an underperforming asset, or buying more of an underperforming asset to ensure you are compliant with a framework that was created to minimise impacts of events that may have catastrophic results on retirement investment portfolios.
If you apply this concept over time, this can hamper portfolio performance significantly.
Over 5 years, the S&P500(foreign) would have more than double(116.34%), while the Top40 would have returned only 67.49%. Combining these in a non-reg28 fund, the returns would be as follows:
However, in a Reg. 28 fund, you would find a significant bias towards the underperforming allocation, particularly new contributions into the fund, resulting in overall underperformance of this fund.
You can test the above theory with other Reg 28 compliant funds. You will struggle to find a fund with long-term returns more than 8% per annum.
The important lesson? The bigger the performance gap between the two allocations, the more underwhelming your overall returns. Returns will be biased towards the majority allocation within the fund. To generate better overall returns, both allocations must perform in similar fashion.
To revisit the question “What do you think a 45% allocation to foreign investment looks like? You can see from what I explored above that you will hardly find a fund that has the maximum 45% offshore allocation. Fund providers will have to remain conservative with their offshore allocations, especially during a period of offshore bullishness. Then during a phase of offshore bearishness, they will look to increase the offshore allocation with a downward adjustment expectation.
It isn’t much help that the JSE has been losing listings while continuing to be viewed as ‘cheap’ relative to other stock exchanges. The economy is under pressure. How long does one continue hoping for a “value unlocking” that will catapult the value of pension investments? I certainly hope this does not end up being another lost decade (or two).
What is the solution?
To improve retirement outcomes, the JSE has to start coming to the party. If the JSE returns improve, the overall health of Reg. 28 investments will also improve.
Whatever the JSE does, or not, you need a contingency plan ASAP.
Realise that your preference for tax-advantaged reg.28 investments is hurting your long-term wealth building ability.
Realise that your stance of wanting to pay as little tax to what is widely perceived to be an underperforming government is hurting you – do not cut your nose to spite your face!
Be prepared to exercise restraint in not accessing your portfolio whenever you feel you could do with withdrawing the money. If you cannot do this, you are better off in poor performing reg. 28 investments.
Have a discretionary fund where you have direct control on the allocations.
Set some rules. E.g., no selling
Let the performance run. Repeat for as long as possible.
Arrive at retirement with much more money than in Reg 28 investments.
What other solutions do you think might help in getting better results? I would love to hear from you.
Kommentare