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In August 2019, the Australian Taxation Office (ATO) wrote to 17,700 self-managed super fund (SMSF) trustees about their lack of asset diversification, and it sparked a flurry of activity from members. The warning came with the threat of a $4,200 fine. The ATO said:
“ … SMSF annual return data indicated these SMSFs may be holding 90% or more of their retirement savings in one asset or a single asset class.”
In 99% of these cases, the SMSF had borrowed money to buy one asset, property. At a time of declining property prices, the concern for retirement savings was justified, but the vast majority of SMSFs do not borrow.
There are over 600,000 SMSFs with 1.1 million trustees, and at the moment, 97% of SMSFs have not received the ATO’s letter. However, another part of the ATO announcement has broader implications. About one-third, or 180,000 SMSFs, invest 90% in a single asset or asset class, and the ATO also said:
“We are concerned that these SMSF trustees may not have given due consideration to diversifying their fund’s investments and the risks associated with a lack of diversification when formulating and reviewing their investment strategy.”
Under superannuation regulations (section 4.09 of the SIS Act), it is a legal requirement for SMSFs to “review regularly and give effect to an investment strategy”, allowing for:
SMSFs make up the largest segment of superannuation assets, as shown below as ‘Funds with less than 5 members’. Worth $750 billion, SMSFs comprise about 26% of all super assets, ahead of industry funds at 25% and rapidly dropping behind, retail funds at 22%.
The non-SMSFs listed above invest their assets as shown in ways shown in the following table.
Some highlights include:
Without going into great detail here, Australia’s $160 billion sovereign wealth fund, the Future Fund, differs from SMSFs even more than other large funds. It holds 29% of assets in global equities and only 7% in Australia, given the far more limited opportunities locally. It has major unlisted investments in private equity, alternatives, infrastructure and timberland.
Surprisingly, there is no definitive source showing total SMSF assets. The ATO issues a quarterly report but it is dated by the time it comes out due to lagging SMSF tax lodgements, and it aggregates categories poorly. For example, it reports managed funds under one category without separating fixed interest, domestic and global equities. The foreign investment number is only direct equities, not including the holdings of Exchange Traded Funds (ETFs), Listed Investment Companies (LICs) and managed funds in global equities.
There are three alternative sources. Researchers at Investment Trends take broad allocation measurements, which also have limited use, while two SMSF service providers, Class Limited and SuperConcepts, reveal what their clients are doing. Class has the larger client base so let’s check what they say on SMSF asset allocation as at 30 June 2019.
Source: Class Limited, SMSF Benchmark Report, June 2019
Like the ATO reports, it is difficult to identify the global equity holdings. The listed shares component can be divided into:
We know from reports issued by ETF providers that SMSFs have moved rapidly into fixed income investments and global equities in the last year, which is heading in the same direction of the large funds. A wide range of listed opportunities which were not available a couple of years ago, such as infrastructure, securitised assets, corporate credit and global fixed interest, are now available in listed form.
SMSF trustees need to understand their legal obligations and learn from the professionals who spend their lives on asset allocation. Some lessons are:
1. Greater diversification balances risk versus return
A diversified portfolio enables an investor to maximise returns for a given level of risk. Investing in a set of uncorrelated income streams can help to manage risk and make a portfolio less volatile.
SMSF trustees should consider less home bias in their equities, and take advantage of global funds with greater exposure to growth categories such as technology and healthcare.
Traditionally, SMSFs had little exposure to direct bonds or bond funds, but this is changing with a wide range of ETFs now covering this sector and attracting large inflows.
2. Identify your risk tolerance for investments
Retail investors with the right mindset do not need to worry about the short-term performance of benchmarks and peers and instead can focus on generating absolute returns within their own financial plan and risk tolerance. A 50-year-old investor can plan for a 30- or 40-year investment horizon if they have the patience.
However, there is no point having a portfolio that keeps a trustee awake at night worrying about market falls. In reality, many retail investors panic when markets hit a bump and they cannot take advantage of a long-term horizon. Large funds seek the protection of defensive assets and the capital gain of growth assets to balance risk and return.
3. Cash provides protection and optionality
While cash is typically the lowest-returning asset class, it gives the ability to take advantage of market dislocations or attractive opportunities as they arise. When markets are oversold, investors can opportunistically deploy capital at attractive prices. It is also the best way to protect capital.
The Future Fund thinks about its entire portfolio as one risk position. High cash holdings allow for market exposure elsewhere, while alternatives might have low expected correlation to equities. A heavy fall in one sector should not severely damage the portfolio, although obviously losses are possible. In extreme markets, correlations can rise quickly and there are few perfect hedges.
4. Watch the expenses of running an SMSF
Large institutions often take market exposure using a mix of index funds and active managers. SMSF trustees should be wary of active managers charging 1% to hug the market index. This shows up in low tracking errors, where results always follow the market. It is now easy for any investor to replace such ‘index huggers’ with a cheap index fund or ETF.
5. Find non-traditional sources of return
Until recent years, it was difficult for retail investors to access alternative assets such as corporate bonds, securitisations, infrastructure, long/short funds and smart beta. The available range has dramatically expanded with hundreds of funds listed on the ASX, accessible in the same way as any listed share (except for mFunds which is an execution service for unlisted funds).
The main legal requirement is to put an investment strategy in place and to review it regularly in the context of risks, returns and cash flow needs. SMSF trustees have significant flexibility in their asset allocation, and if they document their strategy properly, they should be safe from ATO scrutiny, even if their assets are not well diversified.