Download Why understanding asset allocation could improve

Why understanding asset
allocation could improve
your SMSF returns
By Peter Switzer & Paul Rickard
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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.
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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.
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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
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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
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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.
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“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.
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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.
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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,
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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
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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.
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Want to know more?
www.ampcapital.com.au/smsF
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