|Summary: Research shows most SMSFs are taking unintended risks by not being sufficiently diversified in their asset allocations, with a concentration bias to Australian shares and cash. When analysed using a common risk measure, SMSF portfolios are shown to have almost double the risk of a diversified growth fund.|
|Key take-out: The challenge for advisers is to explain the risk drivers that typically flow from the lack of diversification within a typical SMSF portfolio – and ways that can be offset. Risk is an integral part of investing but, for trustees, the challenge may be to understand where unintended risks are hiding.|
|Key beneficiaries: SMSF trustees and superannuation accountholders. Category: SMSF Strategies.|
Risk and return are the inseparable twins of investing. For any given level of return there is a companion level of risk, and generally the higher the potential level of return the higher the risk factor.
The growth in the self-managed super fund segment to the point where it is now the largest component of our superannuation system has been both welcomed as a sign of more Australians being actively engaged with their retirement savings and fretted over by those who would rather people stay within the more paternalistic prudentially regulated institutional funds.
There has been considerable discussion about the potential investment risk embedded within more than 500,000 individual fund portfolios but because of its highly fragmented and individual nature it has been difficult to assess risk across the broad SMSF sector.
However, what we do know from both Tax Office data and trustee surveys by research groups like Investment Trends is the breakdown by asset allocation of where SMSFs are investing.
The Investment Trends SMSF report in 2013 surveyed 1,305 SMSF investors and resulted in a typical asset allocation that was unsurprising in the sense that 45% of the portfolio was in Australian shares, 26% was in cash, 12% in property (both business and residential), 7% was in managed funds while 4% was in listed hybrids and 6% was a range of other.
For SMSF trustees it is probably interesting to overlay your fund’s portfolio against this peer group to see where differences lie.
What is clear from the Investment Trends data is the stark difference between the typical SMSF portfolio when compared against mainstream institutional super funds and the way they build their portfolios.
You could pick any of the major super funds and the portfolios will follow similar risk/return and portfolio construction principles. Certainly there is variation within portfolios in the institutional super fund world but not to the extent of the contrast with SMSFs.
When you compare SMSFs with institutional portfolios the big differences are the concentration on Australian shares and the large allocation to cash or term deposits.
What is clear is that two such different portfolio approaches will have very different outcomes in terms of return and risk.
Vanguard’s Investment Strategy Group is responsible for the asset allocation and investment approach of Vanguard’s internally managed funds and they were asked to develop the risk and return profile for the average SMSF portfolio in contrast to Vanguard’s balanced and growth funds as a proxy for the broader institutional market.
The Investment Trends research data found that the average SMSF holds 18 Australian shares. The portfolio analysis challenge is obvious when you overlay more than 500,000 portfolios on top of the average holding of 18 shares. With such a wide spread of portfolios it is well akin to a random walk across the Australian sharemarket.
So the approach taken was to randomly select 18 shares from the broad Australian S&P/ASX300 index and build 1000 simulated portfolios using historical returns from July 2001 to June 2013.
The other components of the asset allocation were conservatively modelled using a range of market indices such as the UBS Australian bank bill index for the cash component and the S&P/ASX 300 REIT index for property.
We then added two variations to reflect typical SMSF portfolio approaches – one set of portfolios were selected mainly from large-cap stocks and the other selected from high-yielding stocks.
What emerges from the simulated portfolios is that while there is a wide spread of potential return paths the median SMSF return has been strong – particularly in the run up to 2008 – but quite volatile since then and at the end of the period in June 2013 portfolios sourced from the broader market were slightly down on total returns when compared to the two diversified funds. The high yield portfolio’s median return was slightly ahead while the large cap portfolio was between the growth and balanced funds in total return terms.
A strong majority of SMSF trustees – more than 80% according to Vanguard-Rice Warner research in 2012/13) – say they are well-satisfied with the performance of their fund, which is not surprising given they are controlling the investment decisions.
But looking at the other side of the return and risk equation when asked to describe how they invest their fund portfolios almost 60% said “balanced” and 30% opted for “growth”.
Yet when the same portfolios are analysed using a common risk measure – annualised standard deviation over rolling 24-month periods – the results show that these SMSF model portfolios have almost double the risk of a diversified growth fund.
About now a number of SMSF trustees may be shaking their head and thinking my fund got through the global financial crisis pretty well (thanks to the high level of cash) and my Australian shares have done pretty well – particularly when you take into account tax franking credits.
They may well also be thinking that one of the reasons they set up an SMSF was because the portfolios put together by the so-called professionals had lost money at different stages.
The issue here is less about the past performance and more about understanding future risks.
The great attraction of SMSFs is the flexibility trustees have – within the superannuation system framework – to invest as they choose. If people actively choose to take risk within their SMSF portfolio that is primarily their choice – just don’t expect a lot of sympathy from regulators or politicians if you get it wrong.
The question this portfolio modelling raises is, do SMSF trustees appreciate the risk that may be within their portfolios?
If it is a conscious decision to take this level of risk and people are comfortable with it – that is fine, the results will be on the trustee’s head and no-one should be surprised.
But perhaps what is driving the risk factors to such high levels is not well understood and is therefore leading to unintended risks.
The big drivers of the risk within the SMSF simulated portfolios fall into two main categories:
- Equity concentration/home country bias within the Australian sharemarket;
- Large cash holdings generally are a drag on returns over the long term.
In many ways the challenge that comes from this analysis really lands at the feet of the advisers and accountants who work for SMSF trustees.
The challenge for those advisers is to explain the risk drivers that typically flow from the lack of diversification within a typical SMSF portfolio – and ways that can be offset.
Risk is an integral part of investing but, for trustees, the challenge may be to understand where unintended risks are hiding.
Robin Bowerman is Principal, Market Strategy & Communications at Vanguard Australia.