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Where are SMSFs missing the boat?

strategy
By Alexander McNab
April 16 2014
2 minute read
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Despite the sector's increasing growth, many SMSFs are still missing the boat on several asset classes. 

SMSFs are now a prominent feature of Australia’s retirement savings landscape. From a standing start, SMSFs have grown to $521 billion of retirement savings, accounting for 31 per cent of Australia’s total superannuation assets. There have been a number of drivers of this growth, including dissatisfaction with the returns generated by large superannuation funds, the desire among investors to take more control of their financial futures, and the ability of SMSFs to invest in a broader range of assets.

While these benefits are compelling, one of self-managed super’s drawbacks has been the way portfolios are constructed. Australian self-directed investors have traditionally had a strong bias towards Australian equities, property and, to a lesser extent, traditional yielding assets like term deposits.

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Shares have been widely used by SMSF trustees but recent experience (particularly in the global financial crisis) demonstrated how equity market volatility can compromise overall portfolio returns. Residential property lacks liquidity, which poses a problem for older SMSF members, and there are challenges in achieving appropriate levels of diversification. As for cash and term deposits, in a low interest rate environment they struggle to reduce risk, generate an income and drive performance.

Finally, the global financial crisis demonstrated that the diversification benefits of investing across asset classes can be illusory when correlations between these asset classes are high.

Most self-managed super funds have historically had almost no allocation to alternative asset classes, largely because of a lack of knowledge, understanding and access. Alternative asset classes include private equity and venture capital, hedge funds, private real estate and ‘real assets’ like infrastructure, timberland or farmland. The common thread among these asset classes is a risk, return, liquidity and correlation profile different from the traditional asset classes of equities and fixed income.

Institutional investors overseas have long recognised the benefit of substantial allocations to alternative asset classes. According to Russell Investments, international institutional investors allocate 22.4 per cent of their portfolios to alternative asset classes and some very successful investors, like the Harvard Endowment Fund, allocate 60 per cent or more of their portfolios to alternatives. The Future Fund, an early leader in the Australian market, allocates 36 per cent of its portfolio to alternatives.

These investors allocate so meaningfully to alternatives for a number of reasons. Alternatives are typically uncorrelated with equity markets, providing genuine diversification benefits. Alternative asset managers often invest in relatively illiquid markets where assets are more frequently mispriced, creating the potential for strong managers to generate sustained outperformance. Finally, alternative asset managers have a much more strongly aligned fee structure, concentrated on performance fees that reward absolute performance, not performance relative to a benchmark.

Many self-managed super investors are beginning to realise that these benefits apply to them as well. SMSF investors are among the most sophisticated investors in Australia, and many are seeking investments with diversification benefits and the potential to enhance risk-adjusted returns. Liquidity has been a constraint in the past because most alternative asset classes are somewhat illiquid, making them ill-suited to a wealth management model that relies on platforms requiring daily liquidity. However, sophisticated SMSF investors understand that liquidity comes at the price of diversification and returns, and that the long-term time horizons of SMSFs make them the ideal place to consider an allocation to alternatives.

Alexander McNab, investment director of Blue Sky Alternative Investments