Making the most of your SMSF

/Making the most of your SMSF
Making the most of your SMSF2019-01-22T07:05:38+00:00

Making the most of your SMSF

Making the most of your SMSF

Investing for SMSF Trustees

This section is designed to provide SMSF trustees with up-to-date information on:

  • the statutory requirements to have an investment strategy for their fund,
  • calculating whether insurance is needed by the members of the fund,
  • the risks of investing,
  • the importance of diversification, and
  • constructing an investment portfolio for an SMSF during the various stages of its life.

The Rules of Investing and Preparing an Investment Strategy

One of the major benefits of an SMSF is the flexibility given to trustees to directly invest in whatever they want, except for some restricted investments.

Some of the investment restrictions on trustees are:

  • investments must be purchased and maintained at arms length,
  • investments cannot be purchased from members and related parties except in limited cases,
  • In-house assets cannot exceed 5% of the market value of the fund, and
  • investments must be purchased in accordance with the investment strategy of the fund.

This requirement to have an investment strategy comes from SIS regulation 4.09(2). That section states:

“The trustee of the entity must formulate and give effect to an investment strategy that has regard to all the circumstances of the entity, including in particular:

  1. the risk involved in making, holding and realising, and the likely return from, the entity’s investments, having regard to its objectives and expected cash flow requirements;
  2. the composition of the entity’s investments as a whole, including the extent to which they are diverse or involve exposure of the entity to risks from inadequate diversification;
  3. the liquidity of the entity’s investments, having regard to its expected cash flow requirements;
  4. the ability of the entity to discharge its existing and prospective liabilities”.

As a result of the Cooper review into superannuation changes were made to the Superannuation Industry (Supervision) Regulations that apply for the 2013 and following financial years.

Several of the changes directly related to the investment strategy for SMSFs. These were the requirement:

  • for trustees to consider the need for insurance for the members as a part of the fund’s investment strategy,
  • to regularly review the investment strategy of an SMSF,
  • for trustees to keep money and other assets of an SMSF separate from their personal investments, and
  • for all SMSF assets to be valued at market value for reporting purposes.

This means in simple terms the SIS regulations now require that the trustees of an SMSF must prepare an investment strategy at least annually that considers the following:

  • Risk;
  • Liquidity;
  • Diversification; and
  • The need for members to have insurance.

An investment strategy can be as detailed or as summarised as the trustees want, as long as it meets the SIS regulations and is acceptable to the ATO. On the ATO website, in the publication titled, “Guide to self managed superannuation funds”, the ATO provides the following guidance for trustees when preparing their strategy.

The ATO states that trustees need to consider:

  • diversification (investing in a range of assets and asset classes)
  • the risk and likely return from investments, to maximise member returns
  • the liquidity of fund’s assets (how easily they can be converted to cash to meet fund expenses)
  • the fund’s ability to pay benefits when members retire and other costs the fund incurs
  • the members’ needs and circumstances (for example, their age and retirement needs).

Other than these guidelines there is nothing specifically laid down as to how the investment strategy should be drawn up. An investment strategy can be as broad as the trustees want or state expected income yields, set percentages for the various asset classes, and even mention specific investments.

Before documenting the investment strategy for your fund a check should be made of the trust deed of the fund just in case it specifies a form and content that must be followed.

In some cases where an SMSF has one major investment, such as a property, an investment strategy should be formulated that deals with the problems associated with this investment approach. The strategy would need to state that the trustees have considered the risk of having one major asset, the problems with liquidity, and the lack of diversification. The strategy would also need to state how these problems will be dealt with going forward.

Because of the new requirement for trustees to consider the insurance needs of SMSF members the investment strategy of the fund must show how they have dealt with this. Where the members have decided that the cost of insurance is too prohibitive the trustees, like industry and public offer funds, can have their members sign a form stating they will not take out insurance within the SMSF.

Insurance For SMSF Members

Life Insurance

The amount of insurance a person needs is based on two main components. The first amount should pay off any loans of the deceased and their family. The second is the lump sum required to ensure that sufficient income is produced for the dependents of the deceased.

As a general rule the greater the value of loans a person has, the higher the income they are earning, and the younger they are, the greater the amount of life insurance that needs to be taken out. As a person gets older, and their investments including super increase in value, the less they need.

For an example of how an insurance calculation is done click here.

Income Protection Insurance

The rules that apply to how much life insurance a person needs also apply to the other types of insurance that should be considered for SMSF members. The younger a person is, the more income they are earning, and the more money they owe, the higher the monthly amount of income protection insurance they need.

Many people do not take out income protection insurance believing that in the event of something happening at work they will be covered by the workers compensation insurance system.

Given that the quality of most people’s lives is dictated by their ability to earn income, and there can be many accidents and sicknesses that have nothing to do with work, not having income protection insurance when it can be afforded does not make sense.

In some cases income protection insurance can be taken out through industry or commercial super funds at very cheap premiums. The problem is that many income protection policies in superannuation funds only pay benefits for up to two or three years

The main reason for taking out insurance is to cover you in the event of something drastically impacting your ability to earn income for the long-term. It is for this reason that income protection insurance outside of superannuation in many cases will pay a benefit to the insured until age 65.

Although income protection insurance may be more costly outside of superannuation, after taking into account that premiums paid for this type of insurance are tax-deductible, there can sometimes be little difference between the actual after-tax cost of income protection inside and outside of super. Of course if income protection insurance is not affordable having it in superannuation is better than not having it at all.

Total and Permanent Disability insurance

The final type of insurance that should be considered for members of an SMSF is Total and Permanent Disability insurance. This insurance is meant to provide a lump sum in the event of a person becoming permanently disabled so that loans can be paid off, changes made to a person’s home to make it more liveable, and also produce a lump sum to assist in producing an income for the insured and their family.

Even if the calculations show that some insurance should be taken out there are often good reasons why this would not be done within an SMSF. One of the main reasons could be that the cost is too high and earnings of the SMSF would be eroded. The other could be that insurance through an industry fund can be taken out and therefore is not needed in the SMSF.

Whatever decision is made the trustees of an SMSF must document the process and decision in some way.

Insurance Calculation Example

George 40 and Myrtle 35 have two children. George has calculated that the family needs $80,000 a year for their living expenses, but if they had to could live reasonable well on $50,000. George wants to calculate how much insurance the family will need until Myrtle turns 80 if he died suddenly.

$
$

Family Debts

Home loan 200,000
Investment Loan 80,000
280,000
Capital required to produce $50,000 a year with
after inflation return of 2% for 45 years
1,460,000
1,740,000

Less value of Family Investment Assets

Share Portfolio 100,000
Superannuation 300,000
400,000
Life Insurance lump sum required 1,340,000
If George was 55 the life insurance he would need is
$
$

Family Debts

Home loan 0
Investment Loan 20,000
20,000
Capital required to produce $50,000 a year with
after inflation return of 2% for 25 years
810,000
830,000

Less value of Family Investment Assets

Share Portfolio 250,000
Superannuation 700,000
950,000
Life Insurance lump sum required NIL

Risk

Our lives are governed by many laws. There is the law of the land, common law, the laws of nature, scientific law, and the laws of finance and investing. Apart from the laws enacted by the various levels of government, the other laws have at their heart principles and theories that make sense.

Most people would know of Newton’s third law of motion, “To every action there is an equal and opposite reaction”. The equivalent law applying in business, finance and investing is, “the level of return is equal to the level of risk”. An example of this is when someone goes for a loan. The greater risk a borrower has in the eyes of the lender the higher the interest rate charged.

In investing, the greater the risk an investment has the greater the expected return. This is why the interest rate you get on a government guaranteed bank account will be less in the long term than the return you should get from investing in more risky investments such as shares.

With investing there is more than just the risk of losing your money, there are many more that the trustees of an SMSF should take into account when formulating their investment strategy.

Different Types of Risk

Credit risk

This applies to investments such as bonds, debentures and mortgages and can result in income not being paid over the life of the contract, the amount invested not being paid when it is due, or a combination of both.

Currency risk

This affects overseas investments, such as property shares and loans, where their value and return can increase or decrease depending on how the value of the Australian dollar moves in relation to the overseas currency used for the investment.

Diversification risk

This risk can work in two ways. An investment portfolio that is not diversified enough, and therefore concentrated in one class of investment or just one investment in each class, can have its return and value adversely affected.

Where someone over diversifies their investments within each asset class the cost of administering the investments can outweigh the benefits of diversification. Also when someone over diversifies by investing in too many managed funds they can end up paying active fund manager fees but end up with investing in a share index.

Inflation risk

In times of high inflation the actual return and value of an investment is reduced. The aim of an investment policy is to produce a return that is greater than inflation. If the return matches inflation the investor is no better off. If it is less than inflation they are worse off. Inflation risk is why it is important to have investments that not only produce income in a superannuation fund but that also increase in value.

Interest rate risk

In times of falling interest rates the income that had been planned for to fund pensions can fall short. In a rising interest rate market the value of some fixed interest investments will drop due to them paying an interest rate that is less than what the market is paying.

Liquidity risk

Where there are not enough investments that can be converted to cash easily a super fund can be forced to sell an investment at a loss to finance pension payments or other liabilities such as tax. Australia’s love affair with property as an investment class can have serious consequences for a super fund that is paying a pension. If for some reason income drops, due to a tenant leaving, a pension may have to be stopped as there is insufficient cash to fund it.

Market risk

This is the risk that people were painfully made aware of during the GFC. If there are large drops in the value of investments at a time when cash is needed by the fund they may have to be sold as a loss.

Market timing risk

Some people think that they can predict when markets are going to increase and when they are going to fall. This can lead to investments being sold too early when values keep rising. It can also lead to large losses when investments are held for too long and markets crash.

Reducing Risk

Reducing Risk

There are three factors that can reduce the risks associated with investing.

The first is related to the length of time an investment is held.

The longer an investment is owned the lesser the risk of it reducing in value. Another way of putting this is less risky investments can have a short ownership period while more risky investments need to be owned longer. For example cash is a day to day ownership proposition while shares should be owned for at least 5 years.

The time factor especially helps reduce the risk of market timing. Where a conscious decision is made to buy an investment and hold it for a long period, no matter what the markets are doing, the chances of making a loss is reduced. An old investment saying is, “it is the time you are in the markets that makes the money, not trying to time the markets”.

The second factor that reduces risk is diversification.

Diversification means investing in all 6 different classes of investment, Cash, Fixed Interest, Property, Australian Shares, International Shares and Alternatives, and also diversifying within each investment class.

An example of this is a person who invests $100,000 in one company takes a higher level of risk than a person who invests $10,000 in ten companies. While a person who invests the $100,000 with three fund managers, each with a different investing style investing in 50 different companies, will be diversified the most.

The final factor relates to rebalancing the investment portfolio of a super fund.

Rebalancing an investment portfolio occurs when the value of one investment or an investment asset class increases to a point where it greater than a predetermined percentage holding. When this occurs it makes sense to sell down that investment, or investments within that asset class, and invest in other areas.

A good example of this when some SMSF trustees recognised they were over exposed to share markets and sold down some of their share investments, and reinvested into other areas such as cash, before the full impact of the GFC was felt.

A person’s tolerance to investment risk, and how far away they are from receiving a pension from the fund, determines what percentage they should have in each different investment class. Once the upper and lower percentage limits for each investment asset class have been decided they should not be exceeded.

By following this rebalancing principle as different investment classes increase dramatically in value some are sold at a profit, to reduce the percentage holding so it is in line with the investment policy, with the proceeds being invested in the lesser performing investment classes that are often bought at a discount.

The Importance of Diversification

The Australian banking collapse of the late 1800’s, and the GFC, serve as great examples of the fact that investment markets by their nature are unstable. There will always be times of relative stability, but there will also be times when markets get overheated and overvalued, and times when panic sets in leading to markets crashing and investments become undervalued.

Throughout history crashes in markets have not been limited to shares. Anyone around during the recession, the one that Paul Keating told us that had to have, will remember the property crash of the late 1980s.

Most of the data on crashes relate to the US and a look back in time reinforces the fact that booms and busts are a natural part of investing. Since 1825 the US stock market has had 26 crashes of more than 10% and 84 years of growth that exceeded 10%. This fact not only reinforces the boom and bust cycles associated with share markets, it is also reassuring to know that increases outnumber crashes almost four to one.

Ten Worst Crashes Since 1900 and their Causes

10th Worst Stock Market Crash: 2000 – 2002
Key events: Tech bubble bursting, September 11th terrorist attack.
Total Loss: -37.8%

9th Worst Stock Market Crash: 1916 – 1917
Key events: US being drawn into World War 1.
Total Loss: -40.1%

8th Worst Stock Market Crash: 1939 – 1942
Key events: World War 2, attack on Pearl Harbour.
Total Loss: -40.4%

7th Worst Stock Market Crash: 1973 – 1974
Key events: Vietnam war, Watergate scandal.
Total Loss: -45.1%

6th Worst Stock Market Crash: 1901 – 1903
Key events: Assassination of President William McKinley; a severe drought causing alarm about US food supplies.
Total Loss: -46.1%

5th Worst Stock Market Crash: 1919 – 1921
Key events: Followed a post war boom, bursting of the big automobile sector tech bubble.
Total Loss: -46.6%

4th Worst Stock Market Crash: 1929
Key events: End of the roaring twenties, and kicked off the Great Depression
Total Loss: -47.9%

3rd Worst Stock Market Crash: 1906-1907
Key events: The “Panic of 1907” due to a credit crunch in New York, as well as gloom due to President Roosevelt’s antitrust drive.
Total Loss: -48.5%

2nd Worst Stock Market Crash: 1937-1938
Key events: Legacy of Great Depression, war scare and Wall street scandals.
Total Loss: -49.1%

Worst Stock Market Crash: 1930-1932
Key events: Investors lost 86% of their money over 813 days. Combined with the 1929 crash it makes up the Great Depression.
Total Loss: -86.0% Wall Street Crash of 1929

This list of the 10 worst US stock market crashes was prepared before the GFC. Over a period of 18 months the Dow Jones industrial average went from a high of 14,280 on 8 October 2007 to a low of 6626 on 9 March 2009, a fall of 53.6%, making this the second worst market crash. Also in some ways defying logic, given the major economic problems still facing the US, the Dow Jones has since rebounded now to be higher than it was before the crash.

The secret of diversifying the investment portfolio of an SMSF is to get the balance right. Just as the information on the 10 worst market crashes shows that anyone investing in shares must prepare themselves for major drops in value, it is also important to understand that at various times each of the six major asset classes outperform each other.

It is therefore important to understand that when you have too much of your available funds invested in one asset class, such as shares, when things go wrong the damage can be catastrophic.

This need to have a balanced view of investing has been supported by many sources over the years. There is a point of view that states “more value is added to a person’s wealth by getting the balance right between the different asset classes than is added by investment selection”.

In other words by deciding on what percentage you allocate to each asset class, and regularly re-balancing your portfolio, you will add greater value than trying to pick what is going to be the next best share to invest in or who is the best fund manager to invest with.

Australian Best and Worst Performing Investment

The following table shows that the returns for the different asset classes from 1993 to 2012 varies to such an extent that they can be the best performing investment one year and the worst performing the next.

Year

Best Performing

Worst Performing

1993 Australian Shares Cash
1994 Cash Australian Shares
1995 International Shares Cash
1996 Australian Shares International Shares
1997 International Shares Cash
1998 International Shares Cash
1999 International Shares Listed Property
2000 Listed Property International Shares
2001 Listed Property International Shares
2002 Listed Property International Shares
2003 Australian Shares International Shares
2004 Listed Property Cash
2005 Australian Shares Cash
2006 Listed Property Fixed Interest
2007 Australian Shares Listed Property
2008 Fixed Interest Listed Property
2009 Australian Shares International Shares
2010 Fixed Interest International Shares
2011 Fixed Interest Australian Shares
2012 Listed Property Cash

This table shows one of the asset classes as listed property. I believe that for many years the financial services industry has incorrectly classed listed property as a property investment, when in actual fact listed property as an investment is a subset of the all ordinaries index.

The Different Asset Classes

In my investment universe I split investment assets into four classes or categories:

  • Defensive or income assets,
  • Growth assets,
  • Defensive growth assets, and
  • Alternative assets.

Each asset class has different income and risk characteristics. The secret is to blend them depending on your tolerance to risk or what stage your SMSF is in.

In my explanation of the different types of investments I am trying to drill down to the underlying investments and how they behave.

Defensive or Income Assets

Defensive investments are meant to produce income without too much if any fluctuation in their value. They include fixed interest, such as government and corporate bonds, term deposits, mortgages, first mortgages and cash. The reason they are called defensive is because most investors believe that the value of the investment is secure. The truth is some fixed interest investments can decrease in value just like growth investments.

An example of this is government or corporate bonds. In many cases these investments are for a fixed term at a fixed rate of interest. In times of rising interest rates the underlying value of the investment can decrease. If an investor is forced to sell one of these before it matures they can suffer a loss. Conversely when interest rates are falling the underlying value of an investment with a fixed high rate of return will be greater than new investments at a lower interest rate, and they can be sold at a profit.

In addition to the value of one of these investments decreasing because of rising interest rates, investors can also suffer a loss when the borrower defaults and the underlying value of the asset is less than the loan value.

Investing into this asset class can either be done directly, such as taking out a term deposit or investing directly into a first mortgage, or it can also be done through a unitised investment via listed and unlisted trusts.

There have been several much publicised collapses of mortgage funds in recent years but there are some pooled mortgaged funds that have been around for more than 30 years, have survived the GFC, never missed an income payment to investors, and even in this low interest rate environment produce returns well in excess of term deposit rates.

In addition there are index funds available that buy up the investments making up an index. Examples of these in the fixed interest area are the UBS Australian Composite Bond Index and the Barclays Capital Global Aggregate Ex Securitised Index.

Growth Assets

Growth assets are expected to produce some income but most of the return should come from an increase in their value. The value of these investments is often dictated by the principles of supply and demand.

This can come from being listed on some sort of exchange, such as shares, or can come from an open market such as is the case with property. A feature of this investment class is that the underlying value of an investment is not always reflected in its market value.

The secret when investing in growth assets is to not get caught in the hype of whatever is driving a particular market. Instead it is important to retain a clear head and make decisions based on your long term goals.

As Warren Buffet puts it, “Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it”. Putting it another way, when a market crashes it is best not to jump off the cliff with the other lemmings and sell in panic, it is a lot better to be the hawk spotting and buying undervalued investments.

Growth assets are predominantly shares in companies listed on the Australian share and overseas share markets. Taking Australian shares first there are basically three ways of investing in them:

  • Direct share investment,
  • Through an actively managed fund or SMA, and
  • Through an index fund.

Direct Share Investment

Investing directly into the share market can be very rewarding when the companies purchased are held for the long-term. During the recent share market boom that preceded the GFC many investors became day traders buying and selling shares regularly. When a market is rising it is not too difficult to make a profit doing this. Unfortunately, as many investors learnt, when a market crashes this approach can lead to major losses.

Whatever system you decide to use when directly investing in listed shares, whether it is following a share brokers recommendations, subscribing to one of the more reputable share investment reporting services, or from doing your own research, the important thing to remember it is best if you diversify your investment over a number of listed companies that are held for the long-term.

Managed funds

An alternative to investing directly in the share market is to use a managed fund. Managed share funds are split into two types, unlisted managed funds and listed funds known as Electronically Traded Funds. To invest in unlisted managed funds an application must be completed with the fund manager or their admin service. ETFs are managed funds that are purchased on the stock market that replicate the unlisted managed fund.

There are also two types managed funds that depend on the investing methodology of the fund manager. They are active fund managers and passive or index fund managers.

Index funds

A share index is a method of measuring the performance of the whole of a share market, such as the Australian all ordinaries index, or a sector of the market such as the top 200 companies by size.

Index funds tend to be very large as they hold all or nearly all of the companies that make up the index. As no research goes into working out what companies to buy and sell the management fee charged by index fund manager tends to be very low.

Index funds can be used to good advantage when a person wants to invest in a complete sector and use the index fund for rebalancing. Because share markets are often driven by sentiment, such as during the dotcom boom, an index fund allows the investor to be a part of a boom without investing directly in whatever the market loves at that point in time.

When a market has increased beyond what is generally regarded as a sustainable price to earnings ratios the index fund can be sold down with the cash proceeds being invested in other investment classes.

Active funds

Active fund managers hold a much smaller number of companies and are meant to thoroughly research companies before buying or selling them. This amount of extra work means the fee charged by active managers is higher than an index fund manager. This increased fee is meant to be offset by their funds earning more than what an index fund produces.

The unfortunate truth is that many fund managers say they are active, charge active manager fees, but make too many of their buy and sell decisions based on movements in an index. Active fund managers are meant to buy companies that are undervalued and sell companies because they are either over valued or it is time to take a profit.

Within the Australian share market greater diversification can be achieved by not just investing in the top 200 companies. There are managed funds that invest in middle sized companies and also in the small company sector. This small company sector does carry with it a higher risk but has produced at times higher returns.

Overseas share markets

If you think that investing in Australian shares is complicated because of the choices, the overseas share sector has an almost endless amount of choices. It is rare for Australian investors to buy directly into companies listed on overseas share markets. The more common way to invest in this asset class is via managed funds.

This is where the range of choice can be confusing and, for the unwary, can lead to losses. Some international share funds have very little exposure to anything but the American share market, while other funds can have highly concentrated share holdings in other geographic areas such as Asia or Europe.

The differences between Australian share funds can also apply to international share funds. There are index and actively managed funds, and also some that pretend to be active but are in fact benchmark huggers that add little value.

SMA’s

There is now another alternative to managed funds called separately managed accounts. When an investment is made through a managed fund the manager decides what companies to buy and sell and shares purchased are owned by it. In an SMA the investor still gives an amount of money to a fund manager to invest on their behalf, but the shares are purchased in the name of the investor.

The benefits of SMAs are:

  • the shares are owned by the investor,
  • if the fund manager is changed the taxable capital gains impact is reduced,
  • the investor knows what shares are being purchased and sold by the manager, and
  • if decisions are not made on sound investment principles, but appear more to be made as a result of movements in an index, the investor can look for a more active manager.

Defensive Growth Assets

You won’t find this asset class in many books on investing. I have come up with this term for only one asset that has the income characteristics of a defensive asset, but also exhibits the characteristics of a growth asset. This asset is also the investment of choice for many Australians. It is direct property.

SMSFs can invest in property by:

  • buying a property directly if they have sufficient funds,
  • joint venturing in the purchase of a property with members or other superannuation funds,
  • use the limited recourse borrowing rules for self managed super funds, or
  • invest in unlisted property trusts that own either many properties or are a single property trust.

As previously stated I do not believe buying listed property trusts is an investment in property but is more an investment in a subset of the Australian share market.

Unlisted property trusts have the characteristics of a defensive investment due to the regular income they produce but, unlike other defensive assets that are not expected to produce a capital gain; they can increase in value and produce capital gains like growth assets. Unfortunately like other growth assets they can also produce losses.

Research conducted by IPD into the total return for direct commercial property from December 2006 to December 2012 clearly demonstrates the benefits of diversifying into direct property.

Over the six-year period the income return has been between 6% and 8% with capital growth at its highest being more than 10% in 2006 down to a loss of more than 10% in 2008. The average return for this sector from September 1985 until December 2012, based on the PCA/IPD index, has been a combined return of 9.3% made up of 7.4% income and 1.9% capital growth.

By contrast the five year return for the listed property index for the five years ending 31st of March 2013 an overall loss of 9.87% was produced.

Another characteristic of unlisted property trusts, that makes them very much a growth asset, is that they should be held for at least five years and they are illiquid and must be held to maturity. In some cases the funds have set dates for redemption up to seven years from the date of investment.

The long maturity period for unlisted property trusts is another reason to make sure that you get the balance right when putting together your SMSF’s investment portfolio. Losses from a property investment tend to come when a person has got the balance of their investments wrong and they are forced to sell.

Alternative Assets

Alternative assets are often included as part of an investment portfolio to provide some protection from sharp movements in traditional investment markets. Their performance should not be affected by the performance of other investment asset classes. They are often not traded on an organised exchange or are otherwise difficult to access for the average investor.

They include commodities, natural resources, private equity, venture capital, and Agribusiness investments. Unfortunately due to the nature of managed investment schemes that allowed small investors to invest in agribusiness most people have lost considerable sums in this alternative asset class. For this to become a true alternative investment in the future major reforms will need to take place both at a regulatory and investment level.

Alternative investments also include those that do not clearly fit into one of the previous asset classes. This includes hedge funds which employ different strategies, such as long/short and event driven strategies, which make profits from the share market whether it is going up or going down via.

Originally there were not many managers operating in the hedge fund and alternatives area which meant funds were producing above average returns. Unfortunately this superior investment performance led to many fund management companies jumping into the sector which became overcrowded. As a result investment returns for hedge funds were severely reduced.

This asset class can carry with it a higher level of risk than the other investments, but the reason to include them in a portfolio is to provide an investment return that is not dependant on the factors affecting other investment classes. Care does need to be taken when investing in this sector as some fund managers and promoters of alternative investments, such as hedge funds, make it almost impossible for the investor to work out what they are doing.

Risk Profiles and Asset Allocation

What follows are the 5 main investor risk profiles that can apply to superannuation fund members. Over the life of a super fund all 5 risk profiles could be applicable depending on the age of the member, how much is being contributed, and whether they are in accumulation phase or pension phase. The percentage allocated to each class is a very personal decision. The percentages shown are what I regard as prudent but your allocation could differ dramatically.

In my investment profiles the allocations to property is not listed property trusts but direct property or direct property trusts. Some advisors in the financial services sector have classed a person’s home and holiday homes as a property investment. Both of these are lifestyle investments and should not be taken into consideration when putting together an investment portfolio.

Conservative Investor

This profile is applicable to a much older member that has been in pension phase for some time and wants to protect their capital at all costs. They have a short term investment horizon of no more than 3 years and are focused on income and not capital growth.

Asset Class Target Allocation Upper and Lower Ranges
Australian Equities 5% 0% – 10%
International Equities 0% 0%
Property 5% 0% – 10%
Australian Fixed Interest 55% 30% – 70%
Cash 35% 10% – 40%
Alternatives 0 0%
TOTAL 100%

Moderately Conservative Investor

This profile is applicable to a member in pension phase that still needs to have some growth assets to protect them against the impact of inflation. This member would have an investment time horizon of 3 to 5 years.

Asset Class Target Allocation Upper and Lower Ranges
Australian Equities 20% 10% – 30%
International Equities 5% 0% – 10%
Property 20% 10% – 30%
Australian Fixed Interest 45% 25% – 55%
Cash 10% 3% – 20%
Alternatives 0% 0%
TOTAL 100%

Balanced Risk Profile

This profile can suit a member of any age, in either accumulation phase or pension phase, or a combination of both. It would not be suitable where the member is totally risk averse. It provides a good balance between income producing investments and investments held for growth. The time horizon for this member is between 5 years to 50 years.

Asset Class Target Allocation Upper and Lower Ranges
Australian Equities 30% 25% – 40%
International Equities 10% 5% – 15%
Property 25% 15% – 30%
Australian Fixed Interest 25% 15% – 30%
Cash 5% 3% – 20%
Alternatives 5% 0% -10%
TOTAL 100%

Growth Investor

This profile suits a younger member in accumulation phase that recognises the need to concentrate on growth assets. Their superannuation has not yet built up to be of significant value and they have a time horizon of more than 15 years.

Asset Class Target Allocation Upper and Lower Ranges
Australian Equities 45% 40% – 55%
International Equities 30% 25% – 35%
Property 15% 5% – 20%
Australian Fixed Interest 2.5% 0% – 10%
Cash 2.5% 0% – 5%
Alternatives 5% 0% – 10%
TOTAL 100%

High Growth Investor

This is the profile for a member who is just starting out on their superannuation journey with regular contributions. They recognise that the value of their investments will drop at times but they also realise that, as they are contributing regularly, they will gain an advantage of buying investments at the lower value thus averaging their cost.

Asset Class Target Allocation Upper and Lower Ranges
Australian Equities 55% 40% – 55%
International Equities 30% 25% – 35%
Property 5% 5% – 15%
Australian Fixed Interest 0% 0% – 10%
Cash 2.5% 0% – 5%
Alternatives 7.5% 0% – 10%
TOTAL 100%

In the end it is important for trustees of an SMSF to work out what suits their needs and risk profile and set their investment policy accordingly. After all one of the main reasons people choose to have an SMSF is the control it gives them over their own financial future.

Trustees of an SMSF do have a responsibility of understanding what choices they have within each investment asset class. This again is the great benefit of an SMSF, as long as the investment policy and the regulations allow it, the super fund trustees can invest in anything they deem suitable.