SA equities vs Global equities: A risk-adjusted comparison

By Olwethu Notshe, Portfolio Manager at Sentio Capital

Over the better part of the decade, South Africa has had to contend with a series of setbacks that have, unsurprisingly, reduced the attractiveness of the country as an investment destination. The list of setbacks is numerous and well reported on, ranging from state capture, sovereign debt downgrade to junk status and, more recently, FATF grey listing.

The consequences have left South Africa with constrained growth expectations, which range from 1.5% GDP growth without loadshedding to 0.5% GDP growth with average stage 6 loadshedding. This degradation in investor growth expectations has occurred all the while regulations for offshore investing have been relaxed, allowing for up to 45% offshore exposure (as per regulation 28), leaving domestic and foreign investors with the question of how much of their portfolios to allocate to South Africa in lieu of higher growth investment destinations.

As South Africa has become an increasingly insignificant exposure in MSCI EM indices (2023: 3.7%), the question on how much to allocate to the country has become increasingly moot for global investors and more a short-term trading opportunity, as opposed to a structural long-term holding. From the perspective of a South African investor with a rand liability profile, however, the question is more nuanced and requires both return and risk considerations.

Over the long term, SA Equities have outperformed (18% CAGR), although at higher levels of risk (19.9% std deviation). Global Equities also yielded impressive risk-adjusted returns (17% CAGR) at reduced levels of volatility, however with significantly higher drawdowns (50.7%). In the most recent decade, we have seen Global Equities outperform SA equities partly due to cyclical value, the style bucket that most aligns with SA Equities. As seen in the graph below, SA Equities are most correlated to the MSCI World Value index which, up to the covid crisis, had underperformed growth and quality indices.

Decomposing SA Equities further by sector, it is also apparent that SA Equities are significantly more correlated to the MSCI Materials index as compared to MSCI staples and MSCI Technology indices. This is due to the concentrated nature of the SA Equity indices, which essentially renders SA a bet on 3-5 factors. The implication being that when constructing a portfolio of SA equities and offshore stocks, technology and staples sectors (traditionally growth and quality styles) provide the most diversification benefits to an SA equity fund.

This analysis demonstrates that there will be times where SA Equities will outperform its global counterparts, and those periods will likely coincide with periods of strong commodity markets and periods where the value style outperforms. Furthermore, excessive allocations to global risk assets can result in significant drawdowns on the equities themselves, compounded with the excessive sensitivity to the rand, which tends to be volatile.

We believe that the solution to constructing portfolios with global assets is to actively manage the asset allocation between SA and global assets. With more allocation to global assets, the higher the desired growth targets are of the investor. A return profile more than CPI+4% is most likely achieved using the full offshore allocation of 45% and lower return profiles meeting CPI only requiring use of 20% of the offshore allocation.

Caution on currency management, style concentration and other risk exposure management is critical to avoid significant drawdowns. At Sentio, a pillar of our process is the integration of a robust quantitative framework to ensure only as much risk as is required is taken to achieve desired returns and to avoid significant adverse outcomes.