How to increase the diversification of your SMSF
SMSFs are slowly becoming more diversified, but there is still substantial work to do before most are genuinely diversified, as the ATO’s figures show.
According to statistics it published in December 2015, most funds remain skewed to equities and cash. A total of $166.9 billion is invested in local equities, $156.4 billion is invested in cash, $71.5 billion is in non-residential real property, $52.7 billion is in unlisted trusts and $28.6 billion is in other managed investments. This demonstrates the bias most SMSFs have to cash and equities, at the expense of other assets.
Why is diversification important?
The risk of having an SMSF that is not well diversified is that it isn’t as cushioned as it could be against market shocks and volatility. The theory behind a diversified portfolio is that as one asset classes rises, another generally falls, allowing the portfolio to ride out market cycles.
If SMSFs do not have the appropriate blend of different asset classes in their fund there’s a risk the portfolio will experience heightened and unnecessary volatility.
Damian Liddell, a financial adviser with Browell’s Financial Solutions, says a well diversified SMSF should include all the major asset classes including cash, fixed interest, local shares and international shares.
“The right allocation ties into fund members’ risk profile. Often SMSF members have a large allocation to a broad range of shares and assume that this means they are diversified. But that’s not the case if the portfolio does not include a broad range of asset classes,” says Liddell.
Making the assumption the portfolio is diversified is one of the most common mistakes he sees SMSF members make. “People think that they're well diversified, but really they have many assets in the fund that have a strong correlation with each other. So if the share market falls away, it’s likely every share will be negatively impacted. Clients can get a rude shock if this happens, especially if they erroneously assumed their fund was diversified.”
What’s the best way to ensure an SMSF is properly diversified?
Liddell says the first step is to look at the exposures the fund has across all the major asset classes, and make an assessment of how diversified the fund is. Then, it’s a process of working out which asset classes the fund requires to be properly diversified.
“The idea is to have exposure to all the major asset classes, and even go above and beyond that. You can never have too much diversification, so for many SMSFs, the idea will be to try to stretch that out and look at other asset classes that might help improve the fund’s diversification. These may include alternatives and infrastructure, and try to pick assets that have a low correlation with one another or even a negative correlation. The idea is to ensure the value of the fund’s assets are not always moving in the same direction in unison,” says Liddell.
He says it almost never makes sense for an SMSF not to be suitably diversified. “Unless you have a crystal ball, which clearly none of us do, and you can predict that next crash you need diversification. Investors might tactically change their asset allocation, but usually they won’t sell out of an asset class altogether.
“For instance, for most people, their exposure to growth assets might be 50 per cent to 70 per cent of their portfolio. Allocation to growth assets might increase by 10 per cent or 20 per cent depending on market conditions. But it would be unlikely for investors to get out of growth assets altogether.”
Growth assets include local and international equities, as well as property, both Australian and offshore.
If you are concerned about the diversification of your fund, now is the time to review your fund according to your investment strategy and assess whether it makes sense to increase diversification. But it’s important to work out any capital gains tax consequences before selling down any assets to buy investments in order to improve your fund’s diversification.
While there’s no rules around how diversified a fund should be, and the way diversification is expressed will depend on how much risk members are prepared to take on, ensuring there is an appropriate mix of assets in the fund should help protect the portfolio when share markets are bumpy.