March 21, 2009
 By Bruce Cameron
Foreign exchange regulations have been eased to such an extent that you are at liberty to invest a substantial amount of money in a daunting array of products anywhere in the world. We tell you what you need to consider to make the most of the world of investments beyond our shores.
Foreign investment is a key factor that many people overlook until the rand takes another steep dive ... and then they start investing offshore impulsively, often without proper forethought about the products they use and the currencies they choose.
Foreign investment needs to be on everyone’s investment agenda all the time. It should also be part of your carefully considered overall financial plan. Personal Finance looks at the 10 most important issues you need to take into consideration when investing in foreign climes.
1. Why invest offshore?
The most important reason to invest offshore is to diversify your investments by asset class and currency.
Asset diversification. A cursory glance shows that the JSE is heavily weighted towards mining and resources shares, while it is very underweight in some of the major industries, including manufacturing, technology and chemicals.
South Africa is a comparatively small player on the international stock market stage, with only about 400 listed shares compared with more than 14 000 in North America. In South Africa, you do not have access to the world’s dominant companies, particularly in the underweight sectors. This includes major players, such as chemical and pharmaceutical companies Dow, Merck and Glaxo, and technology giants IBM, Apple and Microsoft.
Even when a sector, such as the banking industry, is well represented in South Africa, in the main you are investing in a sector that is affected by conditions that are peculiar to this country, such as interest rates, risk and local consumers’ levels of indebtedness. So the local sector can often perform contrary to similar sectors offshore.
This means that if you invest in South African equities only, you are not properly diversified, because you are not getting a full and balanced exposure to all industry sectors with their accompanying levels of risk, returns and business cycles.
The same applies to the bond market. By investing in South African bonds alone, you are exposing yourself to single country risk. That is, you are investing in the interest rate cycles of South Africa alone, and are increasing your risk by being exposed mainly to the debt of one government and its subordinate institutions. The South African bond market is also mainly comprised of the debt of the government and parastatals, such as Telkom, Transnet and Eskom, while corporate sector debt is very small.
You need to be invested in a broad range of bonds that offer different levels of risk and which are subject to different interest rate cycles.
Currency diversification. The rand is a highly volatile currency, with swings of 20 percent not uncommon. In 2001, the rand lost 37 percent against the United States dollar, after losing 19 percent the previous year. But in 2002, the rand gained 40 percent against the US dollar.
The overall longer-term trend, however, has been a depreciation of the rand against the currencies of South Africa’s main trading partners. The reason is simple. As long as our inflation rate is higher than those of our main trading partners, the value of the rand will decline, on average, to the same degree.
Obviously, other factors are also pertinent, creating short-term volatility. These factors range from perceptions about crime and political stability, to prevailing interest rates.
By investing offshore, you not only earn returns on your investments, but over the longer term you will also benefit from the decline in the rand’s value.
The volatility of the local currency is not unique to South Africa. Over the past 18 months, the US dollar has also taken a battering against European and other currencies. This means you should diversify across the currencies of a number of developed economies.
However, you should not invest in currency-trading products, because currency trading is speculative and is extremely high-risk. Many South Africans have lost substantial amounts of money by investing in currency trading.
J Arthur Brown, the chief executive of Fidentia, started his career in the financial services sector as a currency trader.
Many local investors lost large sums of money in the Leaderguard foreign currency trading scam.
Currency considerations should be part of your overall product choice.
2. The offshore investment allowance
South Africa’s Strict foreign exchange controls, which virtually prohibited any offshore investment, were eased for the first time in 1996, but were based on a complex system of asset swaps, in terms of which any money going offshore had to be matched by inward investments. This complex system has since been dropped, and exchange controls have been gradually liberalised almost every year to the point where the remaining regulations have hardly any impact on ordinary individuals.
The amount that individual residents may invest directly offshore has now been set at R2 million. This is a one-off amount and can be used by any South African resident aged 18 and older who is in possession of a valid tax clearance certificate.
You can access additional foreign investment opportunities indirectly through local financial institutions and an occupational retirement fund.
Individuals who have earned money offshore or who have inherited money in a foreign country may also leave that money offshore. It is not included in the R2 million allowance. Any investment growth earned on foreign investments is also excluded.
In his 2008/9 Budget, Finance Minister Trevor Manuel announced further changes. These included the announcement that controls on institutional investors would no longer be a simple matter of exchange control but rather one of prudential regulation. Institutional investors include retirement funds, life assurance companies and collective investment schemes (including unit trusts and exchange-traded funds, or ETFs).
Prudential investment regulations generally limit how much retirement funds may invest in each asset class. For example, the trustees of a retirement fund are not allowed to invest more than 75 percent of a fund’s assets in equities. This is to ensure that a retirement fund is properly diversified across all asset classes, with the aim of reducing risk.
In the wake of Manuel’s announcement, the limit that life assurance companies can invest offshore was increased from 15 percent to 20 percent of total retail assets, and the amount they and collective investment schemes can invest offshore in an investment-linked business was increased to 30 percent of total retail assets.
Retirement funds are limited to 20 percent of their assets.
These may not be the final levels, because Manuel says further work is still being done on prudential investment limits.
3. How much should you invest offshore?
There is a wide variety of views on how much is the ideal amount to invest offshore, with some of the opinion that up to 60 percent of your investments should be invested abroad.
Some figures seem to be simply plucked from the air, while others are researched.
One method is to use what is called an efficient frontier graph, which shows at what level you receive the optimum returns at the lowest risk. However, the results are not necessarily the same for everyone, because different levels of return will be required at varying degrees of risk.
According to the South African Financial Planning Handbook, Cadiz Financial Strategists did research for the period 1925 to 2005. The company found that the optimum mix for a portfolio aimed at a real (after-inflation) return of four percent over a rolling five-year period would have been 31 percent offshore and 69 percent onshore.
The government feels that, prudentially, you should invest no more than 30 percent of your assets offshore – but then the government does not want everyone in South Africa to invest everything they have in foreign climates, because this would affect investments in production for the local economy.
A third approach is to consider the impact of exchange rates on your living expenses. For example, are exchange rates likely to affect the cost of running your motor vehicle and/or do you travel overseas regularly? If so, you should invest offshore at least to the extent that you want to hedge against prices that will rise as a result of currency depreciations.
The one thing about which there should be no debate is that you should have foreign investments on your investment agenda.
4. Foreign versus rand-denominated
There are two ways to invest in foreign climes: by buying and using foreign currency, or by using rands.
Foreign currency denominated. You in effect buy foreign currency from a local foreign exchange, the dealer transfers the money to an offshore bank and you decide on your investment. You are limited to your R2 million foreign investment allowance.
The advantages of an investment denominated in a foreign currency are:
* Your money is truly offshore. This provides you with far greater freedom of choice. You can invest the money in any thing and in any country you wish.
* Your returns are paid in the currency of your choice, and you can leave your returns and your capital offshore for as long as you like.
Rand-denominated. You can invest rands in products offered by a local financial services company, which, in turn, invests the money on your behalf in foreign investment opportunities. Your capital and your returns are paid in rands in South Africa. You can invest any amount you like and any amount the product provider is prepared to accept.
The main advantages of rand-denominated foreign investments are:
* Affordable access. You can invest as little as R300 a month, as opposed to the large amounts required for foreign investments, where the minimums can be in the tens of thousands. You can invest lump sums and/or monthly amounts, which enable you to have a regular savings plan. Most offshore investments are limited to lump sums.
* Security. Companies that offer rand-denominated products must be licensed by the Financial Services Board (FSB), as must their products. Most of the products are either life assurance endowment policies or collective investments, mainly unit trust funds and ETFs. If something goes wrong with your investment, you can fall back on local regulators.
* Ease of access. When you invest in a rand-denominated foreign investment, there is none of the red tape that surrounds a foreign-denominated investment using your foreign investment allowance.
John Green, the managing director for Africa for Investec Asset Management, says that when choosing between foreign and rand-denominated products, your decision should be based on whether you want to retain the money abroad or whether you want and need your money in rands. If you stay in South Africa and all your liabilities are in this country, it is administratively simpler to opt for rand-denominated offshore funds.
5. Complying with the regulations
Although exchange control regulations have been dramatically eased since 1996, you still need to follow a bureaucratic process when you wish to invest offshore using your one-off R2 million foreign investment allowance.
You must be over the age of 18. You need to obtain a tax clearance certificate from the South African Revenue Service (SARS). The certificate will be issued only if you are registered as a taxpayer and your tax commitments are up to date.
To obtain the certificate, you need to provide SARS with a certified copy of your identity document or passport, and complete a tax clearance certificate application form. The certificate is valid for only three months, so you should have a fairly good idea about how and where you want to make a foreign investment before you apply for the certificate.
The next step is to approach an authorised foreign exchange dealer (most banks have this status), which will apply to the South African Reserve Bank on your behalf. The foreign exchange dealer will need your tax clearance certificate, a completed application form to use part or all of your R2 million offshore investment allowance (obtainable from the dealer) and details of the bank to which your money will be transferred. The dealer will also need an assurance from you that you have not exceeded your offshore allowance.
You will need to meet the requirements of the Financial Intelligence Centre Act (Fica) when you invest using your foreign investment allowance or any rand-denominated foreign investment product. This means you will have to provide proper identification and proof of residence.
There are no restrictions on how and where you use your foreign investment allowance. You can, in effect, use your allowance to fund a party for all your friends and relations at a casino in Las Vegas. But if you blow it all, you cannot benefit from a new allowance to throw another party.
There are also regulations about who can sell you an offshore investment, but these regulations are governed by laws apart from the Foreign Exchange Control Act. For example, any company that sells a life assurance product in this country must be licensed in South Africa, and unit trust funds (mutual funds), as well as ETFs, must meet the local regulatory requirements. For example, hedge funds are not licensed in South Africa.
However, a nudge-nudge, wink-wink situation exists, with many foreign operators marketing products in South Africa that are not licensed. If something goes wrong, the risk lies with you, the investor, because you will not be able to ask the local regulators to intervene on your behalf.
6. Choosing a currency
If you invest in a rand-denominated foreign investment product, you will not have to concern yourself with currencies, because the currency choices will be made by the fund manager. However, if you use your R2 million foreign exchange allowance, you will need to choose a currency.
Charles de Lame, the director of investor services at Sarasin in London, says we have all heard of the sensible reasons for diversifying assets on a global basis, especially after the good run from the South African stock market, but you also need to watch currencies.
"The rand was more expensive in March this year against the euro than it was at the end of 2001 (one euro equalled R12.88 on March 31 this year, versus R12.11 on December 20, 2001), but against the dollar the situation is quite different. The rand was at its worst when one US dollar was at R13.48 on December 20, 2001, but was only R8.12 on March 31 this year."
He says that while it may look expensive to invest through the euro, the US dollar looks reasonable.
The first step in deciding on a currency is to understand how currencies are quoted. They are mainly quoted on the number of rands required to purchase one unit of the foreign currency.
There is also what is called the bid/sell spread. When you buy a currency, you will receive more than when you sell it. This spread will differ when you use a credit card, or trade in cash or telegraphic transfers. The difference covers the costs and profits of the foreign exchange dealer.
Then you may also have to consider what are called "cross rates". For example, the buy/sell spread between two foreign currencies if you are switching currencies and investments offshore.
Exchange rates can add or detract from your investment returns. If the rand strengthens, your returns will diminish; if it weakens, you score. Brian Goodall, who wrote the investment chapter in the South African Financial Planning Handbook, warns it is important that you distinguish between the actual return of your investment in its market currency and the return you receive in rands.
Many rand-denominated funds claim superior investment returns, but these returns are often based on rand depreciation rather than investment skill.
When selecting a currency, you should compare its strength/weakness against other major currencies.
7. Which product?
There are at least 100 000 unit trust (mutual) funds worldwide and then there is the explosion of ETFs listed on international stock exchanges.
The choice is enormous. There is a product for everyone, from something as obscure as distressed municipal debt in the US managed by an unknown fund manager based in Bermuda, to a giant global balanced fund managed by an internationally respected fund manager that is invested in almost every developed economy and in the main asset classes. There are country funds, regional funds, bond funds, broad equity funds, specialist technology funds, private equity funds and hedge funds. You name it and it will be there somewhere.
Picking an investment product from this enormous range would be daunting. But when it comes to selecting your offshore or your rand-denominated investments, you can narrow down the range by following the following guidelines:
A broad-based global managed fund, general equity fund or ETF will suffice for most investors.
Consider using a local product provider. Most of the major life assurance companies and a number of collective investment companies offer products denominated in both rands and foreign currencies. Although the internet gives you access to almost the entire range of investments, you may find it easier if the administrator of your foreign holdings is just up the street. The company and its products will also conform to the local regulations.
Stick to your investment strategy. The most important issue is to structure your foreign investments as you would your local investments. In other words, you must follow the standard investment procedures, such as deciding whether you want income or capital growth or both; knowing the returns you require and the risk you are prepared to accept to attain them; ensuring you are properly diversified; and understanding the costs.
Consider a company with an experienced team of analysts or one that has access to an international investment company with the required expertise.
8. Pooled investments
Very few people can afford to hold a properly diversified portfolio of foreign shares. The answer is pooled investments.
Most formal international investments in security markets are dominated by collective investments, initially unit trust (mutual) funds but increasingly ETFs, which are nearly all passively managed funds that track various indices. There are also life assurance products, but they normally come at higher costs and with contractual obligations that can result in you paying penalties if you do not see out the entire contract period.
Rand-denominated unit trusts are divided into three main categories. They are:
Domestic funds, which must have at least 85 percent of their assets invested in South Africa.
Worldwide funds, which have complete flexibility. They can be 100-percent invested in South Africa or in foreign markets or any combination in between.
Foreign funds, which must have at least 85 percent of their assets invested offshore.
The three main categories are then sub-divided into sectors: equity funds, which are in turn sub-divided by factors such as investment style (growth or value) and market sector – for example: large-capitalisation funds (the major companies); asset allocation funds, which invest in all the main asset classes (shares, bonds, money markets and property); and fixed-interest funds, which include income, bond and money market funds.
These classifications make it easier to select the right investment.
The worldwide and foreign funds are benchmarked against foreign indices, mainly the Morgan Stanley indices.
Most of the rand-denominated ETFs that invest in foreign markets are provided by Deutsche Bank and are known as dbx funds. Deutsche is a major provider of stock exchange-listed ETFs internationally.
9. Tax implications
Tax is an important element of foreign investments. A rand-denominated investment has the least complications from a tax point of view, while a foreign investment in a normal tax jurisdiction can be the most complex. If care is not taken, an investment denominated in a foreign currency could be subject to income tax, capital gains tax (CGT), withholding taxes and/or estate duty in both the foreign country and in South Africa.
The most important factor for South Africans is that with the easing of exchange controls that began in 1996 South Africa changed to a residence-based structure of taxation. This means that if you meet the requirements of being a resident, whether or not you are a foreign citizen, your income and assets in South Africa and in the rest of the world are subject to tax in this country.
One of the few exceptions is pensions received by a South African resident from a foreign retirement fund or a foreign government.
Foreign-denominated investments can be made through what are called low-tax and/or zero-tax jurisdictions, known as tax havens, such as the Channel Islands, Luxembourg, Lichtenstein, Bermuda and Dublin. Your investments and their returns are not subject to taxation by the jurisdictions concerned.
An investment in these jurisdictions is generally referred to as an "offshore investment", whereas an investment in countries such as Britain, France or the US, where your investment will be taxed in those countries, is referred to as a "foreign investment".
If your assets and income are subject to tax anywhere else in the world, and if South Africa has a double taxation agreement with the country concerned, you can, when completing your South African tax return, deduct any tax you have already paid. South Africa has double taxation agreements with most major economies, but you should check.
On your tax return, you include the total amount of foreign assets and income, to which you apply the various exemptions and deductions. The exception is on dividends paid by foreign companies that do not have a listing in South Africa. The dividends are subject to tax at your marginal rate of tax. So-called roll-up funds, which simply add interest and dividends to your capital amount, are subject to CGT.
The situation can become more complex at death with what is called "probate" applying in many foreign jurisdictions. In most cases, you will also need a foreign will to distribute your foreign assets at death.
You can avoid paying double estate duty if South Africa has concluded a taxation agreement with the country concerned.
There are many opportunities for tax planning when it comes to your foreign investments. These include the establishment of an offshore trust, but care must also be taken, because of the expense of a foreign trust, and any careless structuring of the trust can result in unintended consequences. Trusts can be particularly useful if you buy property in, for example, London, because the trust would not be subject to the probate requirements when you die.
10. Beware of scams
The easing of exchange controls in South Africa was an "open sesame" for scamsters worldwide. South Africans could not wait to invest offshore and they fell for nearly every foreign scam going. South Africans gave their money to:
Foreign currency traders, who were simply gambling away the money they received.
People who sold investments wrapped in a legal umbrella product offered by well-known international assurance companies. But investors discovered too late that the underlying investments were being provided on the advice of mysterious third parties based in one part of the world and that the money was channelled through various "investments" and disappearing in a complex paper trail.
Financial advisers who claimed expertise but who were more interested in the high commissions that could be reaped and paid offshore.
Established South African companies that sold products such as capital-guaranteed, index-linked products without properly explaining the downsides, such as that currency depreciation did not apply to your capital.
To avoid becoming a scam victim, make sure you:
Receive sound advice from a well-qualified financial planner, preferably one who is accredited as a Certified Financial Planner by the Financial Planning Institute. Ensure your planner is licensed as a financial services provider by the FSB and is advising you on your other financial needs.
Do not invest in unlisted investment companies.
Avoid product providers and products not registered with the FSB.
Never conduct business solely over the telephone or by email. You do not know where the person with whom you are dealing is located.
Never believe promises of exceptional returns.
Avoid complex products.
This article was first published in Personal Finance magazine, 3rd Quarter 2008.See what’s in our latest issue
  
 
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