Manager Research

2022 was a challenging year for the asset management industry for several reasons. Globally, higher levels of inflation, a crisis in Ukraine and a tightening of the regulatory noose in China all contributed to one of the worst years on record for equities, bonds, and most other risk assets. In addition to that, the South African asset management industry was hit with one of the biggest structural changes that it has experienced in some time.

At the end of February South Africa’s Finance Minister, Enoch Godongwana, surprised the savings industry by announcing that retirement funds could increase their offshore allocation to 45%. Previously, Regulation 28 set this at a maximum of 30% with an additional 10% allowed in Africa. Because African exposure tends to be very limited, the change effectively meant an opportunity for most investors to increase their direct offshore exposure from 30% to 45%.

Figure 1 below looks at how the offshore limits for CISs and Retirement funds have changed over time as exchange controls have been relaxed.

 Figure 1 – Changes to Retirement Fund and CIS Offshore Limits – June 1995 to February 2022

Source: Ninety One South Africa

Offshore investments were first allowed in South African retirement funds in 1995. Since then, we have not seen many asset managers establish fully resourced and competitive offshore investment capabilities as investing outside of SA has grown in importance.

With the most recent change, however, it seems that a tipping point has been breached and many asset managers have had to make material changes to the way they structure portfolios. Indeed, having the ability to invest almost half of a retirement fund offshore has revealed several shortcomings, which naturally make us question whether all managers are capable of handling this paradigm shift.

On the one hand, higher offshore exposure limits present local investors with a larger world of opportunity, which is inherently positive. However, on the other hand, from a research perspective, we still needed to assess whether local managers can effectively manage a material offshore allocation, which has become an increasingly important determinant of future investment success.

In going about that exercise, we’ve had to apply our minds to several focus areas that help us understand (1) how the majority of managers got into this position of vulnerability in the first place and (2) why getting out of that position isn’t as simple as one may think.

Let’s start by looking at the business and commercial implications.

Business & Commercial implications

As is shown in Figure 1, historically, offshore assets have made up a relatively small part of the average retirement fund’s asset allocation. As a result, there has been a limited business incentive for asset managers to build standalone, globally focused investment teams when they are expensive to build and the scope of assets they are likely to manage is relatively small, which made sense. 

As a result, and barring a few exceptions, managers looked to solve this problem by either outsourcing offshore investment management to an ‘aligned’ third party, or alternatively employing a low-cost passive approach. However, as offshore limit levels slowly started to rise, the stress points in these solutions started to become more evident, with the recent material change (a surprise for most of the industry) the catalyst for many businesses having to make structural changes to how they manage money.

Outsourcing a sizeable portion of a fund creates increasing economic disincentives as fees are paid away to an external party. 

With the passive scenario, the alignment of this investment approach to that of a local actively managed approach starts to become harder and harder to defend. 

In both instances and in most cases, business and commercial pressure are now there for funds to change their perspective on how they solve this offshore challenge, to ensure they can put forward something which is both economically sensible, but also ensures the integrity of the overall portfolio is not compromised.

Team resourcing & experience

Instead of focusing on fleshing out their offshore capabilities, many managers have prioritized resourcing for local equity mandates, and for a time on launching local income funds. As a result, many teams and businesses find themselves behind the curve when competing for global assets. Moreover, global asset managers have made substantial inroads into the local market, and they are generally backed by extensive track records, well-run businesses, diverse capabilities and significant assets. Ultimately many local managers may find it challenging to fully resource their global capabilities at this point and catch up with global managers.

Investment philosophy

South Africa’s listed equity market is narrow and as a result, ‘philosophically flexible’ investment strategies have been relatively successful, providing durability through the investment cycle. Essentially, many managers have had to adapt their investment philosophies to suit the SA market. But globally, this isn’t the case. The sheer quantum of opportunities offshore means that managers can build out the ideal portfolio, without the compromise they have to come to terms with, in South Africa. Although this sounds great at first, from our perspective it isn’t all it’s made out to be. The challenge for us is ‘philosophically flexible’ investing works in SA, but not necessarily offshore and we shouldn’t expect the same set of outcomes as a result. Moreover, South Africa’s ‘value’ orientation, means that fund managers tend to align themselves to a complementary process offshore and quite often they are focused on buying stocks from opportunity sets they can’t access locally like global technology (Microsoft, Alphabet, Amazon) or higher quality global businesses (VISA and LVMH). Structurally this makes sense for investors, but it isn’t clear to us that all managers are equipped to add value in these opportunities which most often require a different skillset and investment culture. This is something we will be paying close attention to going forward.

Costs

Local investment costs are higher than they are globally, although they have been coming down. However, global investment costs are also coming down further and size limitations could make it difficult for local managers to compete with their global peers.

Portfolio Integration

Last but most certainly not least is integration. For us, this is one of the most critical aspects of managing a multi-asset portfolio. With an increasing global allocation, inconsistency between the local and offshore components of a multi-asset fund becomes a significant problem. Rarely is it the case, that a fully separate global fund, used within a South African multi-asset fund, is cognisant of the local investor’s needs. As a result, often local portfolio managers are put in a position where they need to account for this inconsistency by offsetting positions within the fund, even though they don’t have the full toolset to do so. Ultimately, it can become quite messy and the overall fund’s positioning may start to look confusing.

Given all of these challenges, how have we generally seen local asset managers adjust their businesses to remain competitive in the future? Apart from a fully passive approach, managers have tackled the offshore problem by adopting one of four strategies.

1. Full Outsourcing

This is where a strategic partnership exists between the local manager and a standalone third-party that manages the offshore component of the fund. There may be some knowledge sharing and cross-skilling, but mostly the offshore component is fully outsourced. Examples here include Stanlib (JP Morgan / Columbia Threadneedle) as well as M&G (via their global parent in the UK). The strength of this approach is that the offshore manager is generally well-resourced and has a mature set of capabilities. However, the drawback is that there is generally a weak level of integration between the local and global parts of the fund.

2.Outsourcing with customization

This is where the bulk of offshore exposure is outsourced to a third party where there is some alignment, and the shortcomings in integration are mitigated by the local fund manager making stock-level decisions on global assets to help build a complete portfolio aligned to investor needs. This matches the benefits of full outsourcing (resourcing, cost scale, maturity) with the limitations (integration) as a best-fit compromise. Examples here include Allan Gray (Orbis) and Coronation (multiple third-party managers within the fund of funds).

3. Integrated Insourcing

In these cases, the local manager has an established capability in managing global assets in tandem with the local assets and implements stock-level decisions across the portfolio.  The main benefit here is that of integration and philosophical alignment, and the main weakness being the burden placed on a single individual or team to cover a wide expanse of global markets.  Examples here include Aylett and the Ninety One Managed Fund.

4. Product-based Insourcing

This is where the manager has a global product – typically global equity – which is then used as a building block within the local portfolio.  This approach is usually followed to provide the manager with a fund to market to direct global investors, but where they can use their domestic funds to help reach some sort of asset size viability.  While the funds are technically managed by the same or related teams, there is often a disconnect between the mandate and focus of the global fund with that of the local fund, creating some alignment issues. Examples here are Camissa, Rezco and Foord.

Importantly, all of the stated approaches above have pros and cons.  Managing a multi-asset, local and offshore-focused portfolio such as that which underpins our savings industry is inherently a complex and onerous task.

Indirectly this has also meant that several of our local managers stack up very well against their global counterparts who are less inclined to take on complex mandates such as this, preferring to specialize in niche asset classes or regions.

So where does this leave us? 

Assessing the implications of these changes is complex and also can’t be undertaken in isolation without considering the full picture for each fund.  When viewed through this lens, and considering a suitable investment horizon, in most cases we can reach a good level of comfort that the structural benefits to investors (increased opportunity set) will be adequately captured by most of the local fund managers we rate, despite the various challenges itemized above. 

We do acknowledge that in the near term, and it has been our recent experience, that there are still meaningful process changes underway which will take time to settle down.  In some instances, these changes may veer off the track we expect and so we will be keeping a keen eye on how the various funds we cover adapt to this paradigm shift.

Ultimately, the local asset management industry is facing numerous headwinds and this recent change adds to the dynamic of which managers will be best positioned to succeed in future.