Spicing up SMSFs

In late June this year the Australian Prudential Regulation Authority (APRA) released a long-awaited magic number that showed total assets held in the Australian superannuation system had finally broken through the $1 trillion mark.

One trillion dollars is a big number and a testament to the robust nature of the nation’s retirement savings system.

The second largest component of that total amount (behind the retail super sector at 32.6 per cent) was self-managed superannuation, which, according to APRA’s March 31, 2007, analysis, accounted for some 23.3 per cent of the total asset pool.

Assets directed towards self-managed funds outweighed even industry funds, public sector, corporate, and small APRA funds.

Reportedly, record numbers of self-managed superannuation funds (SMSFs) were created in the lead up to June 30 this year as the Government’s ‘simpler super’ taxation incentives prompted a rush of new SMSF trust deeds.

It would appear that record numbers of Australians prefer the do-it-yourself option — and the legal and investment management responsibilities it entails — when it comes to managing their retirement savings.

But is this necessarily the best option?

Recent Rice Warner Actuaries analysis showed that about $55 billion of the total SMSF savings pool is actually invested in cash or bank term deposits. A further $136 billion, or 55 per cent of the total SMSF pool, is directed towards direct equities.

On these numbers alone, it could be argued that the average self-directed investor is on the one hand risk averse, on the other too heavily concentrated in one asset class (direct shares).

Risk management

Take a look at the Australian TaxationOffice (ATO) web site and the warnings by the regulator of SMSFs to intending new self-managed super trustees are clear and extensive.

The ATO lists a number of questions people should ask themselves before entering the realm of the self-directed fund trustee and the myriad of rules administered under the Superannuation Industry (Supervision) legislation (SIS).

One of the key issues raised by the ATO relates to the fund’s investment strategy with a particular emphasis on risk.

For example, the ATO points out that, as a trustee, a person is required to prepare and implement an investment strategy for their fund, and regularly review it.

The ATO says: “The strategy must reflect the purpose and circumstances of the fund and consider:

• investing in such a way as to maximise member returns, taking into account the risk associated with the investment;

• appropriate diversification and the benefits of investing across a number of asset classes (eg, shares, property, fixed deposit) in a long-term investment strategy;

• the ability of the fund to pay benefits as members retire and pay other costs incurred by the fund; and

• the needs of members (eg, age, income level, employment pattern and retirement needs).”

Therefore, SMSFs will almost certainly (or should) possess a clearly defined asset allocation and investment policy compared to other investment accounts as a result of the requirement for a documented investment strategy monitored by the regulator.

Smarter investment tools

A key question for self-directed investors and their advisers is whether smarter strategies exist to deliver the combined needs of capital preservation matched with access to growth assets from a broader spectrum of investment opportunities.

Enter structured products, which to some Australian investors may at first glance appear a somewhat counterintuitive, even ‘exotic’ or ‘alternative’ choice.

However, our experience in offshore markets, for example, the European private banking market, clearly demonstrates how investments that are managed within a ‘portfolio context’ can benefit from the asset allocation benefits and risk management capabilities of structured products.

The international experience

European Private Banking portfolios regularly make use of a significant portion of structured products in their overall portfolio makeup.

One of the reasons for this is structured products can be used to alter the risk profile of a portfolio.

For instance, by including capital protected structured products in a portfolio, the risk (specifically on the downside and marginally on the upside) to a given exposure can be reduced. The asymmetry of returns that structured products may offer can also dramatically reduce the risk of the entire portfolio.

Structured products in Australia

The Australian experience with structured products to date has focused on high levels of capital protection and the use of a lending facility to gear into the product.

Investing in a structured product that utilises internal leverage can help SMSF trustees increase exposure to a given asset class, potentially resulting in a higher return.

Additionally, the blending of structured products with more ‘vanilla’ exposures can deliver a desired level of risk or a targeted level of return. All of this can be achieved while remaining within the parameters set by the initial asset allocation or investment strategy.

Structured products can also provide SMSF holders with access to investments not normally available to non-institutional investors.

Recently, we have seen an increasing number of ‘thematic’ structured products. These products aim to capitalise on current investment trends by following a strong investment theme, such as alternative energy or emerging markets.

The principal protection element of some structured products enables investors to control the risk level associated with these ‘exotic’ investment themes, allowing for greater exposure to the underlyings than would ordinarily be rational.

In summary, the SMSF structure is one that is becoming increasingly popular in Australia, but it is certainly not for everybody.

For SMSF investors looking for a smarter strategy to achieve capital preservation while simultaneously maintaining access to ‘riskier’ growth assets, the inclusion of structured products within the portfolio is absolutely an option to consider.

Structured products can provide benefits such as reducing volatility, paying regular income, retrospective allocation and a rising guarantee.

The additional attributes a structured product offers is in allowing the allocation possibilities of the SMSF investment to be increased. What was once classified as solely an ‘alternative investment’ is now more commonly included in traditional asset classes such as Australian equities, global equities, property or fixed income.

David Jones-Prichard is vice-president, equity derivatives and structured products at JPMorgan .