Getting asset allocation right: 2016 and beyond

Looking to next year, how can practitioners help clients construct the best investment strategy for their SMSF, with markets that are likely to remain volatile and interest rates likely to stay low?

As we count down to the end of 2015, we reflect back on a year overshadowed by the Greek debt crises, the rout in the Chinese share market, major terrorist attacks worldwide, a change in Australia’s leadership, and more recently the first US interest rate rise since 2006. On the local market, plunging resource prices led to energy producers, engineering companies and mining heavy-weights being sold off significantly and a myriad of job redundancies. On top of that, a toxic dam burst disaster in Brazil in November saw mining giant BHP Billiton in crises mode, trading at less than half the price it traded earlier this year.

On the Financials front, a change in APRA capital requirements saw a wave of capital raisings from major banks, putting share prices under pressure. Looking across to other sectors, even an old faithful – consumer staple Woolworths, is currently circa 20 per cent lower year-on-year due to problems at Masters, sluggish sales growth and management issues. For diversified investors though, exposure to sectors such as healthcare, telecoms and property would’ve provided some much-needed relief from the sell-off.

According to an ATO report, in the seven years to June 2013, SMSFs posted an average annual return of 4.33 per cent, compared with 3.69 per cent per annum for other super funds. During the GFC period of 2008-09, when markets plummeted, SMSFs outperformed due to higher weighting in cash, large cap stocks and direct property. In these two years, SMSFs lost 5.9 per cent and 6.7 per cent respectively, compared to losses of 8.1 per cent and 11.5 per cent in other super funds.

The report also shows that the three asset classes of Australian Shares (31 per cent), cash/term deposits (27 per cent) and direct property (15%) accounted for 73 per cent of the nearly $600bn in SMSF assets as at June 2015.

With direct property in major cities such as Sydney and Perth showing signs of stagnation, bonds out of favour, and term deposits and other cash assets providing poor returns, how will SMSFs continue their winning performance into the future? As the Australian dollar continues to fall and corporate earnings growth continues to weaken compared to overseas markets, a good strategy may be to diversify into international assets.

With markets expected to remain volatile, managing a diverse investment portfolio with a mix of asset classes such as cash, fixed interest, shares, property and alternative investments, both locally and internationally, is considered crucial to reducing the risk of capital loss and decreasing volatility in the overall investment return.

Getting asset allocation right requires determining a client’s risk profile, long-term investment goals and balancing the expected returns of each asset class – in order to ultimately meet objectives while minimising risk. Generally most super funds will have individualised assets such as direct property investments (residential or commercial), unlisted unit trusts and business interests. Our role as advisers is to ensure that the remainder of the investment portfolio is well diversified in line with above.

Exactly how do we do it? How can we adequately diversify an investment portfolio, minimise risks, as well as costs?

 Three main strategies come to mind:

Selecting individual stocks: A relatively risky strategy given company specific risks as well as limitations to the amount an investor can invest in any individual stock given the size of the investment portfolio. Diversification into international markets can be a costly and time consuming exercise, not to mention the accounting headache at the end of the financial year. However, in a bull market with the correct stock selections, this option will outperform every time.

Managed funds: The majority of SMSF investors have self-managed funds due to the need for more control and visibility into the assets and investments of the fund. Investing in mutual funds through an SMSF may be counterproductive in that respect – and management fees can be taxing on the investment performance. However, a number of funds consistently outperform benchmarks, offsetting management fees payable within the fund.

Exchange Traded Funds (ETFs): More than 100 ETFs are now accessible through the ASX, offering exposure to a wide range of securities, commodities, fixed income as well as currencies. Benefits of ETF exposure in portfolios include significantly lower management fees compared to managed funds, instant diversification by investing into a basket of listed companies, liquidity, and in some cases, franked dividend income payments.

In terms of building international exposure, ETFs are a cost effective option to investing directly, and can offer access to regions and sectors that might not be available directly.

ETFs also offer exposure into currencies and commodities, something that is not achieved easily or cost effectively on all SMSF platforms. As with all other investments instruments, ETFs also have their own inherent characteristics and risks.

Regardless of your chosen strategy to achieve diversification in portfolios, given the current market volatility, three key things to keep in mind for 2016 and beyond:

Know your client’s risk tolerance: It is significantly easier to manage investments in line with the investor’s risk profile, as the investor will be more comfortable during downturns, and less likely to want to exit the market during these times.

Stick with a well-diversified portfolio, and rebalance your portfolios regularly and in a disciplined manner. The media tends to report particular market or share price sell offs. Thankfully it is unusual for all asset classes in a portfolio to drop at the same time. Diversify your investments for this reason – to spread risk.

Keep a healthy cash balance: to ensure that ongoing financial commitments can be kept. This ensures that you won’t need to sell assets at the worst possible time.

Maritza Kriel, director, MK Wealth Solutions