Here's why SMSF asset allocations need to change
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Schroders' David Wanis discusses how SMSFs can improve by exercising flexible asset allocation in pursuit of their objectives.
As part of our team discussions around how investors can achieve the best outcomes from their portfolios, Schroders recently conducted some analysis of ATO data on SMSF portfolios--looking in particular at asset allocations.
Our analysis threw up some key conclusions about SMSFs: compared to other investor groups, SMSF portfolios tend to be inefficient, and also have higher risk and lower performance outcomes compared with mainstream counterparts such as portfolios within super funds, or adviser-led portfolios.
With historically low interest rates around the world, SMSF portfolios are under pressure to deliver meaningful outcomes--and we would say many trustees need to consider making some changes in order to improve their diversification across both the risk and return spectrum.
SMSFs have a clear bias towards Australian equities (often direct and concentrated), property and cash--which under certain market conditions can lead to poor investment outcomes. Increased diversification is an easy solution and a worthwhile goal for most SMSF funds.
However, this doesn't necessarily mean trustees should lock themselves into the strategic asset allocation model favoured by so many other investors.
In our view, SMSF trustees should adopt an active asset allocation approach that considers both prevailing asset valuations as well as their own investment return and risk objectives.
Current portfolios appear inefficient--creating an opportunity for trustees to either increase returns for their current level of risk or reduce risk for their existing return over the shorter term.
SMSF portfolio biases
SMSFs have a number of clear biases in their portfolio construction relative to other investor groups--driven by investment objective, access or tax reasons.
Our key observations from the ATO data on the investment make-up of SMSFs are:
1) A preference to hold Australian equities directly (34 per cent) rather than via managed funds (5 per cent),
2) A preference for Australian equities (39 per cent) vs global equities (1 per cent),
3) A high allocation to property, which includes both commercial and residential (a property class not found in other portfolios),
4) A strong preference for cash over fixed income.
The assumption is that these biases are often tax-driven (property, unlisted trusts) but a number of them also look to be behavioural--based upon what is familiar and accessible (direct Australian equities, cash) rather than what may make most sense to the investment objectives (global equities, fixed income, credit).
SMSFs also have a clear bias towards unlisted property. Given property is now 16.5 per cent of the average SMSF portfolio (versus less than 13 per cent in 2008), we assume the property allocation is relatively fixed.
Hence any increased risk to property returns from here is going to be seen in future portfolio returns--and for what it is worth, we believe these risks are very high.
Other allocation biases also feature over the seven years, with Australian equity allocations (returning +8.7 per cent per annum) held at the expense of higher-returning global equities (returning +12.8 per cent per annum) and the cash allocation (+3.2 per cent per annum) held at the expense of fixed income (+6.7 per cent per annum).
Comparing risk and returns
In order to analyse the risk and return of SMSF portfolios, we have constructed an estimated bottom-up performance series for the SMSF portfolio from June 2009 through to June 2016 (Exhibit 1).
We have also provided two comparator return series to show where SMSF results sit relative to available alternatives:
The Morningstar multi-sector growth category has a similar level of risk to the typical SMSF portfolio although most multi-sector funds diversify into fixed income as well as cash.
This category returned 9.3 per cent per annum versus the SMSF portfolio return of 6.5 per cent per annum (est.) during the time period June 2009 to June 2016.
The Schroder Real Return CPI +5% Fund  has an investment objective similar to the average multi-sector growth fund but targets a lower level of risk.
This fund delivered an improved result to the SMSF portfolio (8.4 per cent per annum) but at half the level of volatility.
Exhibit 1: Return and risk performance, 30 June 2009 – 30 June 2016
Source: SMSF: ATO (2008 – 2014), Schroder Est 2015 &16, Schroder Funds, Morningstar. All numbers gross of fees.
Our analysis is from 2009 to 2016 as all three compared strategies have investment histories covering this period.
We used ATO data for SMSF fund returns available from 2009 to 2014 and have estimated returns for 2015 and 2016.
The graph reinforces our core premise about SMSFs today--that they carry higher risk and lower performance outcomes compared with mainstream counterparts.
The importance of "smoothed" returns
So why should an investor care about portfolio efficiency and the benefits of reduced volatility of returns from diversification?
Well, the simple answer is that converting average asset returns into the compounding portfolio returns that build wealth depends very much upon their path and volatility.
A return of -50 per cent followed by +100 per cent gives us an average of +25 per cent but our starting $100 which declines to $50 and returns to $100 as impacted by those returns gives us a compound return of 0 per cent.
A return of -5 per cent followed by a +15 per cent may look paltry on the average (+5 per cent) but our compounded end point is a bit over 9 per cent.
That is the unarguable mathematics of why a smoother path of returns--all other things equal--is preferred.
But as mentioned previously there is also a behavioural consideration. When faced with a large loss, many investors find it emotionally difficult to maintain an investment program and often abandon their approach precisely at the worst time.
New products helping diversification
One of the core characteristics of SMSFs is a preference to invest directly in listed securities--a tendency that also exacerbates SMSFs' lack of diversification.
However, as more investment solutions become accessible via a listed or quoted ASX structure, we predict SMSFs will take the opportunity to rebalance away from Australian equities and cash over time.
For example, passive ETFs provide diversified exposure to developed and emerging equity markets, domestic and global fixed income, corporate bonds and property assets. These products mean portfolios with excessive biases to particular assets can now be easily changed.
A more recent trend is to exchange-quoted managed funds (EQMFs) which, like their ETF brethren, are exchange-quoted and settled like an ordinary share--but the underlying portfolios are actively managed rather than passively constructed.
Taking an active allocation approach
Although improvements in existing portfolios from a diversification and risk/return perspective should be encouraged, we believe the static asset allocations most people use to weight these investments can bring a whole new set of challenges.
At Schroders, our view is that SMSF trustees should take advantage of their lack of constraints and exercise flexible asset allocation in pursuit of their objectives.
For example, Exhibit 2 shows how the asset allocation of our Real Return strategy, the Schroder Real Return CPI +5% Fund (the fund), compares to current SMSF positioning--highlighting potential areas for improvement or consideration by SMSF investors.
Exhibit 2: Real Return Portfolio vs SMSF Portfolio
Source: Schroders (30 June 2016), ATO (31 Dec 2015). Real Return Fund refers to the Schroders Real Return CPI+5% Fund.
The key portfolio differences are:
• Growth assets--the fund has lower overall exposure to growth assets and improved diversification through global equities and foreign currency. The SMSF portfolio has a clear preference for Australian equity and property assets.
• Diversifying assets--the fund invests in liquid and transparent assets. Within this component of SMSF portfolios are assets such as options, bonds, hybrids, futures, warrants, CFDs and ETFs.
• Defensive assets--the fund is actively managing the fixed interest allocation, despite our concerns about the valuation outlook we do have a small allocation for diversification and protection against a deflationary scenario.
• Dynamic allocation--we have used the asset allocation as at June 2016. However, an objective-based portfolio will respond to the available opportunity and this may change in the future. As an example, in the past 12 months alone our cash weight has varied between 24 per cent and 40 per cent.
The Schroder Real Return Fund
In August, Schroders launched its first managed fund quoted on the ASX--the Schroder Real Return Fund (Managed Fund) (ASX: GROW), based on the above popular real return managed fund.
GROW places emphasis on generating positive real returns while managing volatility and minimising frequency of drawdowns by investing across a broad range of assets. There is also the benefit of regular cash flows.
GROW is just one of a number of new products available via the ASX that can help SMSF trustees to substantially increase the diversification of their portfolio, smooth the return journey, and ultimately achieve better portfolio outcomes.
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David Wanis is a portfolio manager, multi-asset, at Schroders. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind.
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