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What to consider when opening an offshore share portfolio
Many investors favour local shares and are cautious about investing offshore because they feel more comfortable investing in domestic companies they know well. This phenomenon is often referred to as having a ‘home bias’, and can limit the diversification benefits investors derive from investing across geographies. Ray Dalio, founder of the world’s largest hedge fund manager, Bridgewater Associates, is quoted as saying that “Diversifying well is the most important thing you need to do to invest well”. In this article, I consider how investing in offshore shares sets your portfolio up for long-term success.
Diversifying well is the most important thing you need to do to invest well.
Portfolio construction principles
When considering portfolio construction, it is best to apply multi-layered diversification, for example:
Mix asset classes
Mixing asset classes involves spreading capital across different types of investments such as shares, fixed income (bonds), cash and cash equivalents (like money market funds) and real estate. The reason for doing this is that the behaviour of these asset classes differs under varying market conditions. This strategy helps lower overall risk because economic changes affecting one asset class are less likely to have the same impact on other asset classes.
Spread across sectors
Different sectors react differently to macroeconomic changes. For example, the financial sector may deliver better returns than the technology sector during a period of rising interest rates because of bank interest rate margins widening, while tech stocks with higher borrowing costs will be less profitable over the same period. When you construct your portfolio, it is therefore important to ensure that you have exposure across the main sectors such as technology, financials, consumer staples, industrials and healthcare.
Remove home bias and invest globally
Investing in offshore shares can help to hedge your portfolio against localised economic downturns. Concentrating your portfolio solely on the local economy can increase risk as you are not just limiting your portfolio exposure to those shares available on the Johannesburg Stock Exchange (a mere 264 counters), but you are also missing out on exposure to currencies other than the rand. This could lead to the erosion of your US dollar (USD) portfolio returns if the South African economy and the rand underperform. A final consideration is ensuring that your portfolio has exposure to benefit from the growth of companies such as Microsoft, Amazon, Nvidia and Samsung. Investors target these assets for hard-currency exposure, access to dominant tech and infrastructure sectors, and the potential for long-term capital growth.
A key consideration here is that medical costs are often priced in USD. To safeguard your ability to afford premium healthcare in retirement, ensure your portfolio is positioned to deliver global returns that – at a minimum – keep up with medical inflation.
Avoid over-diversification
Limiting your total single stock holdings is an effective way to manage concentration risk. To do this, set clear portfolio limits by capping single holdings – for example try and keep any single share below between 5% and 10% of your total portfolio value. Monitor correlation risk by ensuring that other shares in your portfolio are not in the same industry, as they might be affected by the same market forces, thereby heightening the volatility of your portfolio and increasing the risk of more than one share in your portfolio being affected if the industry underperforms (the semi-conductor industry is a classic example at the moment). Instead, direct all additional cash into underrepresented or underweight sectors rather than adding to your winners. If you need to reduce overweight positions (with share exposure of more than 10% of your total portfolio), start by selling small portions over multiple tax years to reduce the tax impact. When you want to trim positions, setting fixed calendar dates for when to sell (like every six months) helps to remove any emotional bias.
Further considerations when investing offshore for the first time*
If you are a South African investor considering offshore investments, it is important to understand whether you want to invest directly in your name or choose from alternative investment structures, such as retirement wrappers, which may help manage potential additional taxes that could arise on death. Assets held in jurisdictions such as the United States (US) and the United Kingdom (UK) may be subject to situs tax on death:
The UK levies a 40% inheritance tax (IHT) on UK situs assets exceeding £325 000 for non-UK investors, while the US applies estate tax at a flat rate of up to 40% on US situs assets exceeding a very modest $60 000 threshold for non-US investors.
US situs assets include shares in US-listed companies, US real estate, and even cash held in US brokerage accounts. This means that a South African resident with more than $60 000 in US shares may be liable for US estate tax on death – regardless of whether they were purchased via a local platform or a foreign nominee.
South African investors can consider the following options to actively manage this risk:
Invest in non-situs products, for example insurance-linked investment wrappers, exchange traded funds domiciled in tax-efficient (non-US or non-UK) jurisdictions.
Offshore structures: invest in offshore companies or offshore trusts, as these structures can ring-fence assets from situs exposure.
* Note that the above does not constitute tax advice. Contact a tax adviser for further assistance when considering the vehicle best suited for your offshore investment needs.
Common mistakes first-time offshore investors make
The list below is not exhaustive, but includes some of the common mistakes I have observed among clients investing offshore:
Delaying investing offshore due to home bias. This occurs when investors invest only in local markets because they are more familiar with the companies. This prevents them from benefiting from the diversification benefits of investing offshore and gaining access to global currencies and top-quality companies.
Choosing the incorrect investment vehicle upfront. This exposes investors to possible situs tax risks or brings about the need for them to change their investment vehicle – which in turn brings about a capital gains event and the consequent tax that negatively impacts their investment returns.
Waiting for the ‘perfect’ rand exchange rate before converting rand into foreign currency. South African investors primarily focus too much on trying to time currency prices rather than using rand-cost averaging when investing offshore.
Forgetting that the Income Tax Act requires foreign dividends and capital gains to be reported to the South African Revenue Service. Many investors who are new to investing in offshore shares make this mistake. To prevent this, choose a platform that provides tax certificates.
Following the crowd. Once an investor has successfully invested capital into their offshore portfolio, they often make the mistake of investing in popular or ‘meme’ stocks, which are highly volatile. To avoid this pitfall, invest in established companies that pay regular dividends.
Buying into only one sector. Many investors favour the technology sector or the ‘Magnificent Seven’ based on past returns. A more balanced approach is to ensure offshore portfolios are diversified across different sectors.
Conclusion
Investing offshore is an ideal way to diversify investment portfolios. By following some basic portfolio construction principles, understanding the tax implications, and being aware of the common pitfalls, and how to avoid them, you can take advantage of the benefits this investment strategy offers.
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