The role of alternatives in an SMSF
One broad asset class that has received a substantial amount of attention ever since the financial crisis of 2007/2008 is alternatives.
This is a wide category of different types of investments, whose returns are generally different to the major asset classes. So when the value of alternative investments rises, the value of traditional asset classes will fall and the reverse is also true.
The reason they have garnered the attentions of investors since the financial crisis is because many wanted to remain exposed to assets that have the potential to generate a good return, but also want protection in the event the market experiences another substantial decline. This is the role that alternatives generally play in a portfolio.
What are alternatives?
Pete Pennicott, a director and financial adviser with financial advice firm Pekada, explains there are many different interpretations of what alternatives are.
“They are a mix of assets and strategies that sit outside the traditional asset classes of shares, property and cash. There's no one particular asset or strategy that is a catch-all for them,” he explains.
Some of the asset classes they cover include infrastructure, commercial property and managed futures, as well as private equity and hedge funds.
What opportunities do alternatives present for investors?
According to Pennicott, one of the main advantages alternatives deliver is their ability to provide portfolio diversification.
“What you're looking for with an alternative strategy is something that's uncorrelated to the rest of your portfolio's return. A lot of the time, because our clients are overweight to equities, we want something that's going to behave differently to share market returns. Alternatives can provide this, giving SMSF investors some cushioning in bad times,” he explains.
However, it’s important to remember that because alternatives are a broad universe of different asset classes, it’s impossible to generalise about the performance they deliver.
“The return from alternatives varies greatly. The key thing to focus on is the target level of volatility. The level of volatility, which can range from anywhere between 2% up to 15%, will dictate the sort of return you can expect. The main thing to expect in terms of returns is to remember that what you will receive will likely be uncorrelated to the share market,” Pennicott says.
How can SMSF investors access alternatives?
While in the past alternatives have been difficult for SMSF investors to use because they generally require a high initial investment – for instance investing in a commercial property can cost hundreds if not millions of dollars – they are now much easier find.
“You can now access some alternatives through a managed investment or an exchange-traded product, which is a good way to reduce the risks attached to alternatives because these structures provide diversification. It means, for instance, you're not putting all your eggs in one basket through investing in just one private equity fund. Investing in a diversified alternatives fund means investors have access to multiple strategies spread across many different asset classes. So if one investment doesn’t perform, you're not going to blow up your whole portfolio,” he adds.
Alternatives and asset allocation
One of the decisions SMSF investors have to make is the proportion of the portfolio that will comprise alternatives. Pennicott reminds investors the right composition of the portfolio will depend on the members’ own situation.
“The allocation should match the overall objective of the fund. For most of our clients, the share of the portfolio alternatives comprises is somewhere between five per cent to 10% of overall holdings. This gives investors sufficient diversification benefits without being overly weighted towards alternatives,” he says adding that Australia's sovereign Future Fund has about 13% allocated towards alternative strategies. This is largely because it invests in large infrastructure projects.
No investment strategy is without risks and alternatives are no exception. Pennicott says one of the major risks is liquidity, which is the threat investors won’t be able to easily sell an asset and realise their investment, because many assets are not listed on stock exchanges and easy to buy and sell.
“These assets generally don’t have daily liquidity, where you can get access to your money quickly. So just make sure that the money you are investing can afford to be locked away for long periods of time,” he adds.
Alternatives have emerged as an important option for all investors. But like any asset class, it pays to do your research before taking a decision to invest.