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How to diversify your SMSF portfolio to manage risk

How to diversify your SMSF portfolio to manage risk

Diversification is an important consideration for an SMSF trustee when formulating the fund’s investment strategy. Here we take a look at what that means in practical terms.

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. 

Two options providing easy access to diversification are managed funds and exchange traded funds (ETFs)

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 meanwhile 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.

Managed funds and ETFs 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.

Conclusion

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.

This article is intended to provide general information of an educational nature only. It does not have regard to the financial situation or needs of any reader and must not be relied upon as financial product advice. Investors should consult a range of resources, and if necessary, seek professional advice, before making investment decisions in regard to their objectives, financial and taxation situations and needs because these have not been taken into account. Any securities or prices used in the examples given, including but not limited to Exchange Traded Funds, are for illustrative purposes only and should not be considered as a recommendation to buy, sell or hold. While potential SMSF investments have been illustrated they do not represent a comprehensive suite of possible investment products and services within the guidelines pursuant to the SIS Act 1993 with ATO oversight. Past performance is not indicative of future performance. Taxation considerations are general and based on present taxation laws and may be subject to change. You should seek independent, professional tax advice before making any decision based on this information. Commonwealth Bank is also not a registered tax (financial) adviser under the Tax Agent Services Act 2009 and you should seek tax advice from a registered tax agent or a registered tax (financial) adviser if you intend to rely on this information to satisfy the liabilities or obligations or claim entitlements that arise, or could arise, under a taxation law. Commonwealth Securities Limited ABN 60 067 254 399 AFSL 238814 (CommSec) is a wholly owned but non-guaranteed subsidiary of the Commonwealth Bank of Australia ABN 48 123 123 124 AFSL 234945 and a Participant of the ASX Group and Chi-X Australia.