Are SMSFs on a path to disaster?
There is considerable asset allocation bias with SMSF trustees. This is likely to lead to disappointing performance at best, and widespread disasters at worst, according to Dominic McCormick.
In recent years there has been considerable gloating from supporters of self-managed superannuation funds (SMSFs) that their investment performance has, on average, been better than retail or industry funds.
While it is hard to find definitive data to confirm this, it is true that some major asset allocation biases of SMSFs – as revealed in administration platform and the Australian Taxation Office statistics – have likely assisted their relative performance through much of the past decade.
These major biases are:
- A very high weighting to cash, term deposits, and to a lesser extent, other fixed interest.
- A major bias to Australian shares (and very little in international shares); and
- A large and increasing exposure to Australian direct residential and commercial property (increasingly through geared arrangements).
The latest survey from SMSF administrator Multiport reports that the average asset allocation at 31 December 2012 was 35.4 per cent Australian shares, 38.3 per cent cash, term deposits and fixed interest, and 17.6 per cent property (mostly direct).
That leaves just 8.8 per cent in everything else – global shares, alternative investments, collectables, etc.
To these biases, could be added a generally static approach to asset allocation and a rather passive approach to security selection – especially in Australian equities, where the top 10 stocks by market capitalisation dominate holdings.
Arguably, the most prominent asset allocation decision lately has been to let cash/term deposits build up further as received from contributions and dividends/distributions – especially post global financial crisis (GFC).
Gearing arrangements mainly into direct property have also recently become more popular.
So far, these allocation biases have left many SMSFs relatively well placed through the difficult years of the early to mid 2000s, and to some extent through and since the GFC.
However, it is time to raise some challenging questions:
- Have these allocation biases been the result of apathy, luck or purposeful and well thought through design?
- As a result of the relative outperformance, have SMSF trustees become complacent and overconfident in their own abilities or have they become apathetic?
- How well do these biases position members for the future?
- Will these portfolios meet the retirement income needs of each SMSF member?
My view is that the historic asset positioning of the average SMSF has been driven by inherent behavioural preferences and therefore any resultant outperformance is due to luck.
Trustees have clearly focused on the assets they know best and those that best reflect the “control” element that is a driver to setting up many SMSFs.
Cash and term deposits from well known financial services groups, “brand name” Australian shares and particularly “bricks and mortar” that they can touch and feel – all provide this feeling of familiarity and control.
Indeed, I suspect many SMSF trustees have little idea about the basic principles of sensible asset allocation and portfolio construction.
In one industry roundtable discussion conducted in 2010, an industry professional was quoted as saying “one of the marketing strategies we’ve always adopted when talking to SMSF investors’ directors is you never talk about asset allocation because their eyes just glaze over”.
This relatively successful positioning to date and the focus only on what trustees are most comfortable with has contributed to a dangerous complacency regarding investment issues amongst many SMSF investors.
If new contributions are being directed to cash and term deposits, a few blue chip shares, or tied-up in servicing geared property arrangements, there is hardly any scope to consider asset allocation/portfolio construction properly, or the potential wisdom of adding other investment areas.
The big concern is that these three key asset biases are resulting in SMSF portfolios that are poorly diversified, inflexible, lacking in many asset areas that currently offer better value/prospective returns, and neglecting assets/strategies that can reduce relevant risks in a portfolio.
Indeed, “risk” is almost certainly widely misunderstood and underestimated by many SMSF members.
Because they often have high levels of cash/term deposits, there is an assumption that this must lead to a low risk portfolio.
However, risk is not one-dimensional, and while a high level of cash may reduce the chance of poor short-term nominal returns, it may well also increase the risk of not meeting longer term cash-plus/inflation-plus objectives, which is what superannuation is ultimately about.
Further, I believe the three major asset allocation biases, despite being different asset classes, are actually all heavily exposed to just the one broad macroeconomic risk – the Australian economy’s dependence on China.
Consider this scenario.
A severe slowdown in China sees commodity prices and volumes fall sharply.
The Australian economy moves into recession, with unemployment rising significantly. Residential and commercial property falls in value.
The Australian share market, with almost two thirds in resources and financials performs poorly. The Reserve Bank of Australia responds and cuts interest rates aggressively. The Australian dollar falls in response.
The average SMSF would do quite poorly in this scenario, as all three of the above asset biases detract value.
The attractive cash/term deposits rates currently available would quickly fade and funds would have to be reinvested at much lower rates.
The Australian share market would lag global markets, particularly in AUD terms, as the weakening currency boosts unhedged overseas shares.
Residential property would struggle with current low yields failing to offset the cost of finance in geared arrangements – even before considering capital losses.
Many commercial properties would also be under pressure as the recession bites economic activity.
Meanwhile, the average SMSF would have very little exposure to the areas that could do relatively well in this environment.
Global share markets less exposed to China would most likely outperform – especially given the currency boost from a falling Australian dollar.
A number of alternative investments could do well in this environment – for example, managed futures and selected hedge funds.
More diversified property and infrastructure investments – with less gearing and more liquidity – would be less vulnerable than geared arrangements into single illiquid assets.
Of course, this is only one scenario, but it does highlight how poorly diversified the average SMSF currently is.
The relative underperformance of the Australian share market over the past 12-18 months may be an indicator of what is to come.
Further, investors in Australia – having largely escaped a property crash during the GFC – should not assume that this risk has disappeared.
It is worth focusing more on geared property arrangements, as this is where I believe many SMSFs are most vulnerable to disappointment in years ahead.
While there are some technical gearing strategies that can make sense for super, I believe many direct property gearing arrangements will prove disastrous for SMSFs, providing a major policy headache for future governments.
These gearing arrangements are often excessively exposing SMSFs to a single asset that is expensive, inflexible and illiquid, going against basic principles of sensible investment.
Some funds are setting up such arrangements, paying interest at 7-8 per cent per annum while continuing to sit on large cash holdings earning no more than 5 per cent per annum. Again, this fails the ‘investments 101’ test.
I think it is inevitable that the regulators/government will again be forced to constrain such arrangements in the future, but if history is any guide, it will only be after they have proved wealth destroying for enough investors.
Again, the comfort and ‘control’ with bricks and mortar property is a key driver, as well as the ease and aggressiveness with which some property developers, banks, accountants and real estate agents can aggressively spruik gearing into property.
So what, in my opinion, should the average SMSF be doing differently?
- Holding less in cash/term deposits – especially if members have many years left in the accumulation stage;
- Being more cautious on the types of fixed interest holdings they do have exposure to, given the historically low bond yields and high debt levels of some of the large constituents of some global bond indices;
- Investing more in global shares – I believe the current environment is providing good opportunities for global stock pickers, and there will be an additional boost when/if the Australian dollar falls;
- Reduce the Australian shares component and make it more diversified and value focused – this involves picking stocks or using managers with a reduced focus on only the top 10 stocks which is dominated by resources and banks;
- Greater exposure to high quality alternatives less reliant on rising equity markets for return – eg, managed futures, selected hedge funds, commodities and precious metals;
- Avoiding or being very careful with direct property – especially in geared structures that overly expose funds to one possibly overvalued and illiquid asset.
- Becoming more active in asset allocation – this is not about active “trading”, but being prepared to periodically adjust the portfolio in a contrarian sense when valuations are attractive and pessimism is excessive, and when assets become overvalued and sentiment overly optimistic.
Financial planners can play a valuable role in assisting trustees to build better portfolios, and I would hope that those SMSFs influenced by advisers are more diversified than the average.
Unfortunately, I suspect many financial advisers involved with SMSFs have become less active regarding investment advice to them in recent years.
Partly, it’s the direct control that the typical SMSF investor seeks, but it’s also partly a response to the challenging environment of recent years where product and asset recommendations by financial advisers – some along the above lines – would have been seen to have failed, at least to date.
That doesn’t necessarily make these recommendations wrong now, and may strengthen their case, but many financial planners seem to have decided that it is best just to give SMSF investors what they want, rather than what they need.
This is disappointing, but it’s not too late to adopt more proactive messages to SMSFs when it comes to portfolio construction and asset allocation.
The funds management industry in particular needs to do a better job communicating how its offerings can help achieve sensible and more diversified portfolios for SMSFs.
SMSFs are clearly here to stay, but their dramatic growth, opportunistic approach, and their “lucky” investment performance historically has resulted in an increasingly ingrained neglect of sensible portfolio construction and diversification.
As typically occurs in the investment industry, this neglect is only likely to be corrected after the flaws in current arrangements are fully exposed – which is typically after they have turned sour.
Meanwhile, there is a valuable opportunity for financial advisers with the courage to challenge the lazy or apathetic investing habits of many SMSF investors – even if recognition of their value may only come in future years.
Unfortunately, it seems few financial advisers are currently taking up this challenge. (Refer to Table 1.)
Dominic McCormick is the chief investment officer at Select Asset Management.
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