South African equity funds: A turning point

Source: Supplied. Michael Dodd, senior fund analyst at Morningstar SA.

"Its long overdue introduction is a welcome step that improves comparability between South African equity funds and has been necessitated by the increases seen in offshore investment limits over time, which rose to 45% in 2022," said Michael Dodd, senior fund analyst at Morningstar SA.

"We are supportive of the changes Asisa has made to its Fund Classification Standard. An effective classification system allows for better performance comparisons between funds that are operating with the same investable universes and under the same constraints.

"The separation of SA-only and General Equity funds is a positive step towards fairer performance assessments, and provides plenty to consider for investors, allocators, and asset managers."

SA-only & General Equity funds

Previously this category saw a mix of South African Equity funds, and peer-group comparisons became less and less meaningful as returns and a fund’s relative ranking in the category were being driven by the performance differences between the local and global equity markets that also, in turn, got amplified by currency fluctuations.

Our latest research explores the changes to the South African General Equity categories. For brevity, we refer to funds in the new ‘South African – Equity – SA General’ category as ‘SA-only’ equity funds and those remaining in the old ‘South African – Equity – General’ category as ‘General’ equity funds.

How did we get here?

Despite recent challenges in the South African equity market, ranging from lower-than-average returns to a rise in JSE delistings, South African Equity funds remain well-supported, with over R500bn in assets as of October 2024, with the two General Equity fund categories accounting for roughly 95% of these assets.

The market share of SA-only funds has increased over time, now accounting for 42% of the assets in South African Equity funds. This is partly due to the rise of passive investing and the preference of allocators to separate local and offshore equity allocations.

However, another area that grew was the dispersion between the returns of South African Equity funds. This has been driven by regulatory increases in offshore limits and the subsequent use of that offshore allowance by funds in the category whose mandates allowed it.

Notably, the varying use of offshore allocations in General equity funds causes performance dispersion among South African equity funds to spike when the performance gap between local and global equities is widest.

The new Asisa fund category goes some way to improve comparability between South African Equity funds. In looking at returns from these funds, there has been a far wider range of outcomes for General equity funds versus those of SA-only equity funds.

This is understandable, given that the investable universe of SA-only equity funds is far more homogeneous than that of General equity funds, whose opportunity set is far broader. The calendar years of 2022 and 2023 provide interesting case studies of this, and what was required to be a top-performing South African Equity fund in those particular years.

2022 was a year in which the local equity market outperformed the global equity market in rands. The All Share Index (Alsi) returned a positive, but unexciting return of +3.6% in 2022.

In contrast, the MSCI World Index delivered a negative return in rands, falling -12.7% as global equity markets experienced a significant drawdown. Funds with minimal offshore exposure performed better in this environment. The 2022 returns of South African Equity funds ordered from highest to lowest illustrates this, with each respective fund’s median offshore weight for the year depicted by the orange dot.

In contrast, 2023 was a very different year. While the Alsi delivered a decent return of +9.3% that year, global equities rebounded strongly as the MSCI World Index delivered a return of +33.0% in rands. In that market environment, funds with higher offshore exposure performed better. The median offshore weight of a top quartile fund in 2023 was 23%.

There are several things that become clear when looking at the data:

• Peer group performance comparisons for South African Equity funds became increasingly difficult over time. In certain years, the extent of a fund’s offshore exposure was a key determinant in its peer-group ranking in that particular year.
• Many funds in the category weren’t making use of the offshore allowance that the old category did allow. This would have either been driven by the manager’s preference, or by the mandate of the fund.
• Using offshore allowances in years favouring global equities didn’t always guarantee better performance outcomes. In 2023, many funds with offshore exposure still underperformed the peer-group average. Thus, while getting the offshore exposure call right was important, effective management of that exposure was equally crucial.

Where are we now?

As of 15 November 2024, there were 67 different funds in the new SA-only category and 152 different funds in the General equity category.

The largest funds in the General Equity category include the Allan Gray Equity Fund, which has a size of R46.3bn and an offshore allocation of 42%, the PSG Wealth Creator Fund of Funds at R26bn with 26% offshore exposure, and the Ninety One Equity Fund, valued at R14.7bn, with a modest offshore allocation of just 2%.

Interestingly the majority of South African Equity funds, including those in the General equity category, are currently using very little of their offshore allowance.

For General equity funds, this could be due to two possible reasons, namely:

• Optionality: Those funds currently do not use their offshore allowance, but they are retaining this optionality to potentially make use of this allowance in the future, and
• Pending reclassification: Those funds intend to change categories, but missed Asisa's deadline for the implementation of the new fund category.

The lack of consensus on the usage of offshore allocations by General equity funds highlights the ongoing transition within the South African Equity fund landscape. The consensus is that the asset-weighted average offshore weight for South African Equity funds has changed over time, and has changed significantly for the funds currently in the General equity category.

It is evident offshore weights in South African Equity funds are increasing. Driven by regulatory increases in the offshore limit, the asset-weighted average offshore weight in South African Equity funds was 13% as of September 2024. When looking only at General equity funds, this sits at an asset-weighted average offshore weight of 22% at the same point in time.

Where are we going?

The new Asisa Fund Classification Standard is in its infancy. Once the dust settles, we believe that there are a few potential trends that could emerge in the South African Equity fund landscape:

Different target markets: SA-only equity funds have generally been preferred by allocators such as discretionary fund managers (DFMs) and multi-managers, who typically prefer to separate the management of their offshore equity allocations from their local equity allocations. General equity funds have typically been preferred by retail investors.

Choice of benchmark: SA-only funds are naturally likely to opt for a local market index as their choice of benchmark. For General equity funds the choice is more complex. The use of a local market index is less appropriate here, especially if the fund is making use of its offshore allowance. Composite benchmarks, made up of weightings to both local and global market indices, and the use of the category average as a benchmark has become more prevalent among General equity funds.

Index funds: The SA-only equity fund category is likely to become the home of index funds going forward. This is understandable, given that these funds track local market indices, aligning their investable universe.

Offshore exposure: The average offshore weight in the General equity category is expected to move higher as funds not making use of their offshore allowance reclassify. Funds that have used their offshore allowance sparingly in the past may need to consider this allocation and the impact it may have on peer-relative performance.

Product proliferation: New fund launches may target different client types, particularly if firms do not have a product offering in one of the equity fund categories. This could lead to even more funds for sale in a market where the number of South African Equity funds on offer already outnumbers the number of shares in the FTSE/JSE All Share Index.