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Achieving SMSF goals with ETFs

Many objectives of SMSF members, including diversification, cost-effective investing and periodic portfolio rebalancing, can be achieved easily through the use of exchange-traded funds, writes Shaun Parkin.

The unique attributes and benefits of exchange-traded funds (ETF) appeal to both institutional and individual investors. Typically structured like managed funds, but listed and traded on an exchange like stocks, ETFs are flexible trading and investment vehicles that can be used to help the SMSF investor satisfy a number of critical investment needs.

Risk and the SMSF investor

Managing your own retirement assets requires thoughtful consideration and careful planning. We will focus on one important factor that will help our efforts and drive our current discussion on equity ETFs in Australia: risk.

An investment in equities represents fractional ownership in real companies and carries with it all the risks and potential rewards of owning any business. In terms of the risk scale, equities lie on the riskier end of the spectrum when compared with bonds. Generally speaking, the longer an SMSF’s time horizon, the greater the risks it can take. This is simply because potential losses in the short term may be made up in rebound years that will likely follow recovery years. In addition to time horizon, as a general rule the greater your current retirement assets are and the greater your ability is to save in the coming years, the greater your investment risk appetite will be.

A long time horizon and ample savings will generally mean an investor will be able to invest in higher-risk assets with potentially higher returns, including investments such as stocks and ETFs based on stocks. SMSF investors who are able to invest in equities must be educated about the different options available to them in the marketplace. Further, they should weigh up the many factors – ease of access, associated fees and expenses, ability to attain proper diversification at a reasonable cost and adequate transparency – to make intelligent and timely portfolio decisions that may determine which investment vehicles are most appropriate for them.

The benefits of ETFs

ETFs are investment funds that trade just like stocks. They are referenced via a ticker on an exchange such as the Australian Securities Exchange (ASX), but represent a broad index of assets such as the 200 largest Australian stocks by market cap in the case of the SPDR S&P/ASX 200 Fund. An ETF will trade at or close to its net asset value and is available to be bought or sold whenever the exchange itself is open for business. As they can for stocks, investors may use limit orders to buy or sell ETF units at desired levels, or stop orders to insure against losses beyond some unacceptable limit. An investment in a managed fund does not offer the benefit of continuous trading. Also, unlike managed funds, the holdings of most ETFs are fully transparent and available daily. This full disclosure enables investors to make more informed portfolio decisions with greater accuracy. ETFs often have lower costs and fees than comparable managed funds due to their lower overhead and staffing costs. But even beyond straight fees and expenses, ETFs are generally more tax efficient than their managed fund counterparts. Managed funds are subject to investor turnover that often results in the selling of fund holdings and in turn the distribution of capital gains. These capital gains will result in taxes that are absorbed by all investors. ETF investors can decide when to sell their ETFs and any associated capital gains taxes are paid at the time of final sale, offering greater control on the timing of tax consequences.
Factors such as these make ETFs one of the cheapest, simplest, most tax-efficient and most easily accessible investments in a well-diversified basket of equities for the SMSF investor.

SMSFs

SMSFs account for 30 per cent of all superannuation assets in Australia, with over $530 billion in assets, and are growing at a rapid pace. SMSFs provide their members with control over the range of their investments, the fees being charged, the amount of tax being paid and the ability to include other family members in the fund.

Although SMSFs tend to have lower operating costs, they lack the heft and resources of their large superannuation fund counterparts. Indeed, the value proposition of lower fees and greater control were central factors for the vast majority of investors who decided to start their own SMSFs. ETFs can add immense value by providing SMSFs with a well-diversified, low-cost and easy-to-understand asset allocation, tax management, portfolio rebalancing and transition management tool.

Uses of ETFs for SMSFs

Asset allocation and the core-satellite approach to investing

Experienced SMSF investors are discovering what institutional investors have known for some time: asset allocation, not security selection, can help drive long-term investment results. Asset allocation refers to the selection of an appropriate asset mix (for example, 70 per cent stocks and 30 per cent bonds) that will differ for each investor, depending on their ability to take on risk. Asset allocation strategies have historically been difficult for many SMSF investors to implement, given the cost, research efforts and asset size required to achieve an appropriate mix and a proper level of diversification. However, since their launch, ETFs have been good choices for investors wishing to gain broad-based Australian stock market exposure through low- cost, easily accessible exchange-traded products. These ETFs can form the passively managed equity core of an SMSF investment portfolio that has the ability to take on equity risk. Allowing a significant share of an SMSF portfolio to be invested in a passive vehicle like an ETF can help the members avoid costly fees and expenses associated with investing with an external manager. In addition, investors can save valuable time and resources necessary to research a plethora of possible investments and come up with a well-diversified portfolio on their own.

Despite investing part of the portfolio passively, core-satellite investors do not totally rule out the possibility of investing in good ideas they are able to uncover on their own. They can then take the remainder of their investable assets and invest in satellite positions in the hope of generating alpha or excess returns.

Tax management

Although ETFs are tax-efficient vehicles that allow investors to time tax consequences of capital gains, they can also be used to help SMSFs in accumulation mode minimise their tax bills in other ways. ETFs are able to do this by passing through franking credits from the distributions they receive from constituent companies. Franking credits represent company taxes already paid on corporate profits and can be passed along to investors with normal distributions as an IOU from the ATO. This credit in essence eliminates the double taxation of profits at both the corporate and personal level.

Rebalancing

As investors near retirement they may choose to position their investments more conservatively and opt for a higher-yielding equity ETF. Alternatively, if an investor would like additional diversification in high-yield property-related stocks, they could invest in a listed property ETF. Or investors could simply opt to reduce their equity exposure altogether, which ETFs allow at any time. The targeted exposure and deep liquidity of ETFs allow for the simple implementation of periodic portfolio rebalancing. At its most basic level this will involve buying or selling ETFs, individual stocks in relatively small amounts to re-establish the fund’s predetermined asset allocation and core-satellite positioning. Rebalancing for ETFs is as easy as buying or selling a few shares of stock, however, SMSFs that invest with managed funds may find rebalancing more difficult because of restrictions and fees on short-term buying and selling of units.

Short-term cash management

ETFs can provide a ready, liquid and low-cost investment to help bridge the gap between two other investments. If an SMSF redeems from an external manager or some other investment, and plans to roll the proceeds into a new investment that it has not decided on yet, an ETF could be used as a temporary placeholder for those assets. An example of this transition management process could involve an institution choosing to reduce its large-cap equity exposure in order to take advantage of opportunities it is seeing in the commercial real estate sector. After liquidating the fund’s equity holdings, the fund then has the choice of immediately investing in an ETF that will continue to hold its place in large-cap equities, or it could opt to invest in an ETF to approximate the returns of its new real estate investment until it can be finalised.

Direct access to investment opportunities

ETFs are a highly effective way to access the growth potential across asset classes, without the complexities of a direct investment or challenges of a managed fund. By investing offshore, investors can potentially benefit from lower asset prices, new growth opportunities and more effective diversification. Given these benefits, an allocation to international equities could suit investors who are looking for capital growth in preparation for retirement or looking to move their current cash holdings into growth assets.

Considered a defensive asset, fixed income is another asset class that SMSF investors should consider when planning for retirement. Fixed income investments are designed to achieve stable returns in the form of income, often with little or no capital growth. This is in contrast to other asset classes, such as equities, or growth assets, which aim to increase in value over time, generating strong returns in the form of capital growth. In the same way shares pay dividends, bond investors can also receive a regular income stream in the form of coupon payments. For investors, understanding this risk-return balancing act between the performance of growth and defensive asset classes is fundamental to achieving a well-positioned portfolio for retirement. Whether you are seeking low-cost diversification, an easy-to manage core portfolio holding, or cost-effective exposure to the long-term structural themes reshaping the global economy, ETFs are an option worth considering.

Conclusion

SMSFs are at the cutting edge of retirement planning for individual investors in Australia as the government attempts to encourage us to become more involved in the process. SMSFs, however, must be careful to recognise the double-edged nature of this control. With greater control comes greater responsibility. SMSF trustees have proudly accepted this mantle and have shown that with the proper encouragement and training, managing one’s own retirement assets can be a cost-effective and financially empowering undertaking. ETF use among SMSFs has grown in recent years because investors have realised the immense value proposition of an easy-to-access, low-cost and tax-efficient tool to attain equity diversification through a single investment. Through the continued use of ETFs as asset allocation, tax management, rebalancing and transition management tools, their usefulness to the SMSF investor should only grow in the years to come.

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