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Transcript
Why understanding asset allocation could improve your SMSF returns By Peter Switzer & Paul Rickard BROUGHT TO YOU BY AMP CAPITAL WELCOME To put together a comprehensive investment strategy, and maximise the returns of your self-managed superannuation fund (SMSF), an understanding of asset allocation is vital. This is the process that tries to balance risk and return by allocating different amounts of your portfolio to different kinds of investments. The key asset classes of shares, property, fixed income, cash, infrastructure and alternative assets (hedge funds or private equity) can all play a role in an SMSF’s investment portfolio, the key is finding the right balance. Shane Oliver, Chief Economist and Head of Investment Strategy at AMP Capital says: “The risk-return tradeoff is at the heart of asset allocation. Each asset class has a different level of return and risk and each behaves differently over time.” What you need to do is to work out how much risk you are prepared to tradeoff for how much reward, and vice-versa. All investors want to maximise returns, but nobody wants to lose all their money either. From Peter Switzer and Paul Rickard The advent of the global financial crisis (GFC) certainly highlighted the importance of not having all your money in the one basket. Investors that suffered most from the collapse of various funds and investment vehicles in Australia, were those that had all of their portfolios in suspect products. If they had been more diversified they would have been much better off. BROUGHT TO YOU BY AMP CAPITAL CONTENTS Why is asset allocation important?.......................................... 03 What is dynamic asset allocation?............................................05 The role of DAA in managing your SMSF................................. 07 The role of tax......................................................................... 09 Final note................................................................................ 10 Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice. BROUGHT TO YOU BY AMP CAPITAL Why is asset allocation important? A variety of things will contribute to the performance of your fund. Of course there is your ability to actively exploit market inefficiencies and choose investments that provide optimal returns – this is called active management. It contrasts with passive investment management, which involves investing in line with an index. Asset allocation is also an important determinant of performance. It might surprise you to know that many studies* have shown that it is actually asset allocation, rather than your investment ability, that is the prime determinant of portfolio performance. Different asset classes will outperform, or underperform, during different periods of time. The following chart shows annual returns for the years to 2012 and 2013. As you can see, if you had bet on Australian shares continuing to outperform after 2012 and put all your eggs in that basket, in 2013 you would have missed out on the outperformance of residential property. The objective is not to pick the winner each year, but to diversify sufficiently as to benefit from each asset class’s winning year, and not be too exposed to their bad years. “But this all changed with the GFC.” *For articles on the importance of asset allocation see R.G. Ibbotson. “The Importance of Asset Allocation”, Financial Analysts Journal. Mar/Apr 2010. Source: Russell, ASX 2014 Long-term Investing Report 03 BROUGHT TO YOU BY AMP CAPITAL Sometimes the benefits of diversification are not obvious. For example, during the 1980s and 1990s the returns of the two main asset classes – shares and bonds – moved together. approach to diversification. The Switzer Super Report example investment strategy suggests the following: “The Trustee has considered the diversification of the Fund’s investments and is of the opinion that the strategy is appropriate given the size of the Fund in terms of both investments and the number of members.” “But this all changed with the GFC,” Oliver points out. “Market volatility and poor returns put the spotlight back on asset allocation.” Your investment strategy needs to include some indication that asset allocation has been adequately considered. You should include a section in your written investment strategy document that explains your Australian Shares International Shares Property Australian Fixed Interest International Fixed Interest Cash You will also need to set target weightings for each asset class which could include ranges as well. The following is purely an example. Range Benchmark 40% - 60% 0% - 20% 0% - 15% 0% - 20% 0% - 15% 1% - 20% 50% 10% 10% 20% 5% 5% Source: Switzer Super Report 04 BROUGHT TO YOU BY AMP CAPITAL What is dynamic asset allocation? There are various theories around portfolio management followed by institutional fund managers. There are also a number of theories around the different kinds of asset allocation which may be useful to SMSF trustees. These can be broken down into three categories, which relate to different time periods. The other two kinds of asset allocation are tactical asset allocation, or TAA, and dynamic asset allocation or DAA. TAA involves changing your asset allocation based on short-term movements in asset classes or stocks and is more the domain of the day trader, or very active fund manager, than the SMSF trustee. We have strategic asset allocation or SAA, which is the kind of asset allocation we have discussed above in reference to your investment strategy. Your SAA will take into account your investment goals and what you want your SMSF to achieve over the long term. However dynamic asset allocation involves medium-term adjustments to the strategic asset allocation, which can be useful for doit-yourself superannuation funds. The following chart helps illustrate the three approaches to asset allocation. Source: AMP Capital, for illustrative purposes only. 05 BROUGHT TO YOU BY AMP CAPITAL “A DAA process plays an integral role in achieving portfolio objectives as it can capture shorter term market opportunities and market inefficiencies to enhance returns.” Oliver points out that SAA is a fundamental building block of an investment strategy, however: “due to its inherent long-term nature, SAA is not well equipped to respond to market swings and fluctuations and shorter term opportunities.” “This is where a DAA process plays an integral role in achieving portfolio objectives as it can capture shorter term market opportunities and market inefficiencies to enhance returns.” A real-time example of DAA that SMSF trustees can relate to might be positioning a portfolio for an eventual rise in the Australian dollar. At the Switzer Super Report, we have been expecting a stronger US dollar for some time. Now the US is showing signs of a sustainable recovery, we are confident the Australian dollar fall is not too far off. Therefore we have been suggesting to our readers that now might be a good time to start positioning their investments for a lower US dollar. These kinds of portfolio changes, which fit in between your shorter term and longer term movements, come under the umbrella of dynamic asset allocation. 06 BROUGHT TO YOU BY AMP CAPITAL The role of DAA in managing your SMSF Dynamic asset allocation is important to all investors but is particularly important to SMSFs. As a trustee, you will not be adjusting your portfolio daily – i.e. conducting tactical asset allocation – but you will be monitoring it regularly. This will involve readjusting to make sure the strategic asset allocation is maintained, but also implementing movements in accordance with your views on bigger events, such as the currency movements discussed above. “The starting point for returns today is much less favourable than when long-term bull markets last started in bonds and shares in 1982,” Oliver says. This means that dynamic asset allocation will continue to be important in the future, particularly as the range between the returns of the major asset classes is likely to be wide. The below chart includes AMP Capital’s current forecast returns for the major asset classes and shows a range of just 3% per annum for Australian Government bonds to just over 10% per annum for Asian shares. Thankfully the GFC is behind us. However, its legacy is still with us. Source: AMP Capital. Data as at June 2014. Past performance is not a reliable indicator of future performance. 07 BROUGHT TO YOU BY AMP CAPITAL There will always be investment cycles, during which different investments outperform. The important thing is to be realistic about your adjustments during cyclical periods and to always be mindful of your strategic asset allocation. tight monetary conditions and investor euphoria,” Oliver says. The oracle of Omaha, Warren Buffett, famously outlined one of these elements when he said: “You want to be greedy when others are fearful. You want to be fearful when others are greedy.” “Cycles are of particular importance because they can throw investors off a well thought out investment strategy that aims to take advantage of long-term returns. They can also cause problems for investors when they are in, or close to, retirement,” Oliver says. Looking for these rhyming elements can help you with your DAA. Returning to our lower Australian dollar (A$) example, if you bought companies now that could benefit from a falling A$, you might not see immediate gains, but you will be well-positioned when it does happen, and you will have also bought your stock at cheaper prices. One of the residual problems of the GFC was that spooked investors, including many SMSF investors, reallocated to safer investments such as cash. Of course you would have missed out on the massive gains in shares over the past 18 months if the majority of your holdings were in cash. It is almost impossible to pick the exact bottom, or exact top, of a market cycle but there are signs or ‘rhyming elements’ that give some indication of what might happen next. “One of the residual problems of the GFC was that spooked investors, including many SMSF investors, reallocated to safer investments such as cash.” “While investment cycles do not repeat precisely, they do rhyme. Each cycle has common elements – e.g. downswings in shares are usually preceded by overvaluation, 08 BROUGHT TO YOU BY AMP CAPITAL The role of tax Depending on what stage your SMSF is in – accumulation or retirement – your tax position will be different. After-tax returns may be more important for investments outside of superannuation but they do bear weight for SMSF investments as well. The following chart shows the long-term after-tax annual returns for the lowest and highest marginal tax brackets and also superannuation in accumulation stage. In pension phase, where no tax is payable, your return will be the gross return for most asset classes. Due to the power of franked dividends, it will be even higher than the gross return for Australian shares. performance expectations. The chart highlights the power of franked dividends and why many SMSF investors sometimes run an overweight allocation in Australian shares. For example, a pretax average return of 8.7% per annum in Australian shares becomes 9.1% for an SMSF in accumulation paying tax at 15%, and even higher for an SMSF in pension. In relation to any dynamic asset allocation adjustments, SMSF trustees need to remember that shares held for less than 12 months won’t be eligible for the capital gains tax discount. The capital gains tax discount available to SMSF trustees, at 33.3%, is less than the 50% available to investors outside of superannuation. However, the tax rate in super is also just 15%, which means the discount will result in capital gains tax of only 10%. Capital gains losses can only be offset against future gains although they can be carried forward indefinitely. A tax-efficient investment strategy should take into account potential tax liabilities; it could allocate less to these investments, while of course taking into account Source: Russell, ASX 2014 Long-term Investing Report 09 BROUGHT TO YOU BY AMP CAPITAL Final note An understanding of investing theory can be very helpful to the SMSF trustee. Having a framework and structure about how you invest, can insure that you keep to your goals. It is critical that when the unexpected happens, you don’t fall into the traps of switching to safety, or switching all your investments to the fastest-growing asset class of the day. Dynamic asset allocation gives you flexibility to adjust for investment cycles without the day-to-day monitoring that would be required of tactical asset allocation. When used with a well thought out and documented strategic asset allocation, dynamic asset allocation can assist outperformance and reduce losses. PETER SWITZER Peter Switzer is one of Australia’s leading business and financial commentators. He is the publisher of SMSF newsletter the Switzer Super Report and co-founder of the Switzer Group, a media and financial services organisation that provides information, education and advice to investors and SMSF trustees. PAUL RICKARD Paul Rickard is the founding CEO and Managing Director of Commsec and was named Australian Stock Broker of the Year – Hall of Fame in 2005. He is a leading authority on investing in self-managed superannuation and is also a director of the Switzer Financial Group. 10 BROUGHT TO YOU BY AMP CAPITAL Want to know more? www.ampcapital.com.au/smsF BROUGHT TO YOU BY AMP CAPITAL