Things to consider when diversifying a retirement fund

With the changes to Regulation 28, many retirement fund trustees are keen to increase their exposure to these markets. However, it is crucial that trustees have a granular understanding of their current exposure before making any decisions.

This is according to Quaniet Richards, Head of Institutional at Nedgroup Investments, who says while diversifying into Africa and into Emerging Markets is certainly a good diversifier, there is a lack of understanding of the risks of investing in Africa and the existing exposure to Africa through the listed South African investments.

“The important thing to remember is that many locally (South African) listed companies derive a significant portion of their income and profits from regions and countries in Africa, ex-South Africa. African investments are subject to a unique set of political, liquidity, sovereign and currency risks and it’s crucial to make sure one is not unintentionally doubling up on these risks by investing in two companies with the same, or similar look-through exposure,” he says.

Have a granular understanding of the portfolio’s current exposures

Over the past decade, South African corporates like MTN, Shoprite, Tiger Brands, the banks and insurers, expanded their operations into Sub Saharan Africa.

This means investing in these companies will automatically provide some exposure to the broader African environments in which they operate.

If you invested in a Zimbabwean bank and you own a South African bank with operations in Zimbabwe, the portfolio’s exposure to the Zimbabwean banking sector increases. If the Zimbabwean regulator decides to implement legislation that negatively impacts banks, both the South African bank and the Zimbabwean bank may be negatively impacted - a double whammy for the investor. Furthermore, it would be nearly impossible for the investor to sell their holding in the bank in Zimbabwe due to liquidity constraints.

“This is not to say avoid African, ex-South Africa investments altogether – but a reminder to make sure that trustees are aware of the exposure of the portfolio on a look-through basis to avoid doubling up on risk factors,” says Richards.

What to consider when investing in Emerging Markets

Richards says the same approach should apply to emerging market exposure. 

“Most developed-market stocks, like Airbus SE, Philip Morris International Inc and Nestle SA, derive a significant proportion (40% and above) of their revenues in emerging markets. These stocks are often held in emerging market portfolios. Therefore, before investing in emerging markets, trustees should conduct a careful portfolio analysis of existing exposures through the current developed market equity portfolios and the South African portfolio.

The regional revenue breakdown of emerging market companies is also important as the companies may not offer as much exposure to emerging markets as you think. “Companies are increasingly diversifying their businesses into developed markets. Just look at some of our SA listed companies – Compagnie Financiere Richemont SA and Aspen Pharmacare Holdings that derive more than 40% of their revenue in developed markets while South Korean listed Samsung Electronics derives more than 50% of its revenue in developed markets,” says Richards.

Contagion effects within emerging markets can have a negative impact on South African portfolios as illustrated by the recent effects of sanctions levied on Turkey. We saw a broad sell off in emerging market currencies, bonds and equities. “This shows us that South African markets unfortunately cannot escape this wave of negative sentiment – SA is one of the most liquid emerging markets after all,” he says.  

The key?

Know what you are invested in and understand what you are going to invest in as this will assist in portfolio construction and the optimisation of risk-return dynamics. Richards urges trustees to select a manager who has a long term, proven track record of outperforming the benchmark; with deep insights; performs in-depth analysis and risk management; and offers reasonable annual total investment charges.