SMSF Portfolio Analysis: Asset Allocations need to change
In this paper David Wanis shares our key observations on the investment make-up of SMSFs, which when compared to other investor groups, tend to be inefficient with higher risk and potentially lower performance outcomes. David 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 Australian Taxation Office (ATO) data on SMSF portfolios – looking in particular as 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 toward 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 favored 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%) rather than via managed funds (5%),
2. A preference for Australian equities (39%) vs global equities (1%),
3. A high allocation to property, which includes both commercial and residential (a property class not found in other portfolios),
4. A strong preference to 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% of the average SMSF portfolio (versus less than 13% in 2008), we assume that 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% p.a.) held at the expense of higher returning global equities (returning +12.8% p.a.) and the cash allocation (+3.2% p.a.) held at the expense of fixed income (+6.7% p.a.).
Comparing risk and returns
In order to analysis 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% p.a versus the SMSF portfolio return of 6.5%p.a. (est.) during the time period June 2009 – 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% p.a.) 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 – 2016 as all three compared strategies have investment histories covering this period. We used ATO data for SMSF fund returns available from 2009 – 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% followed by +100% gives us an average of +25% but our starting $100 which declines to $50 and returns to $100 as impacted by those returns gives us a compound return of 0%. A return of -5% followed by a +15% may look paltry on the average (+5%) but our compounded end point is a bit over 9%.
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 that 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
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% and 40%.
The Schroder Real Return Fund [ASX: GROW]
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 whilst managing volatility and minimising frequency of drawdowns by investing across a broad range of asset. 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.
Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article. They do not necessarily reflect the opinions of Schroder Investment Management Australia Limited, ABN 22 000 443 274, AFS Licence 226473 ("Schroders") or any member of the Schroders Group and are subject to change without notice. In preparing this document, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was otherwise reviewed by us. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this article. Except insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this article or for any resulting loss or damage (whether direct, indirect, consequential or otherwise) suffered by the recipient of this article or any other person. This document does not contain, and should not be relied on as containing any investment, accounting, legal or tax advice. Schroders may record and monitor telephone calls for security, training and compliance purposes.