Alongside ensuring the SMSF is maintained for the sole purpose of providing retirement benefits to its members, SMSF trustees are obliged to consider diversification as a part of their fund’s written investment strategy.
Why diversification is important for SMSFs
Diversification aims to spread your SMSF’s investment risk so that if one asset performs below expectations, the performance of other assets can offset this and keep your fund on track to meet its investment objectives.
Diversifying across uncorrelated assets, such as shares and bonds, also makes it possible for investors to lower the volatility of the portfolio.
The idea here is that because these asset classes typically move in different directions in response to a certain scenario, such as an interest rate move, the portfolio can generate more consistent returns.
Investing across asset classes can also help with another thing trustees must consider – namely liquidity, or how easily the fund’s assets can be converted into cash.
SMSFs need ready access to cash so they can pay administrative expenses, income tax and minimum pensions when they are due. So, it’s probably best not to have all your fund investments in fixed assets, such as property.
In addition there’s some important risks such as sequencing risk that can be minimised through a well thought out diversification process.
What does a diversified SMSF portfolio look like?
For SMSFs the obligation to consider diversification is commonly expressed as a target allocation for each asset class and the acceptable range of variation from this target.
This then provides a relatively simple way to see how the portfolio aligns with the guidelines set out in the investment strategy.
Within large APRA-regulated super funds, asset allocation will change periodically throughout a member’s life depending on how close they are to retirement when reliability of income increases in importance. SMSFs would be wise to follow this lead.
Generally, however, while the proportions may change there will typically be a mix of cash, fixed interest, property and infrastructure, Australian shares, and global shares.
The chart below shows these asset classes and their sub categories, which represent different methods of gaining access to them.
Importantly diversification is both allocating among a range of asset classes, and then also diversifying within each asset class.
- Diversification between asset classes involves having an asset allocation that consists of a range of different asset classes.
- Diversification within asset classes involves having a range of different investments in each asset class.
How can you make sure you are diversified?
Accessing some of these asset classes can present challenges to individual investors and SMSFs because they may have minimum investment requirements, or other ownership restrictions that add complexity.
ETFs aim to replicate the performance of a particular index or group of assets, effectively giving an investor exposure to an entire market or asset class. For example, it is possible to buy ETFs that track specific share markets, for example the US, Japan, Europe or Australia or sectors or themes, such as small cap stocks or high yield stocks or asset classes such as commodities, bonds or property.
A managed fund pools money from multiple investors, then professional managers invest this in a variety of assets, which could be global or local shares, offshore property, infrastructure, or high-yield investments in line with a stated objective.
ETFs and managed funds make accessing investments in a broader diversified manner much easier. Few SMSF investors can get adequate diversification across international markets. Even domestically niche areas such as small or microcap stocks can be handled with less risk using a professional manager.
Again with property, few investors have the ability to gain sector access alone and this can be done with less risk via A-REITS (listed on the ASX), ETFs, managed funds or property syndicates.
It’s easy for SMSFs to become focused on stock picking and trading, activities that are exciting and time-consuming. However, it could be more beneficial to step back and take a broader view and ensure that you have the right balance in the key asset classes and adequate diversification within them. At a higher level the SMSF investment decisions are simplified, and they may even be more profitable, at the very least less volatile.
Asset allocation and diversification are the key components of your investment strategy, but you don’t have to face them alone. These decisions are often best tackled alongside an accredited adviser who can help set the guidelines and parameters of the strategy and be a trusted sounding board during regular reviews.