Looking for diversity, growth and protection

Achieving a variety of investment goals is becoming increasingly difficult in the current economic climate. Olivia Engel examines typical SMSF portfolio allocations and the associated pitfalls that may exist with them.

In the current world economic environment, where ‘lower for longer’ is the mantra around interest rates, and ‘low and slow’ is the expectation for economic growth, finding strong sources of return for your investment portfolio is a challenge. Add to that the impact of market shocks and volatility spikes and investing in 2016 has been something of a wild ride.

So as the year draws to a close, investors should consider asking themselves the following questions when deciding what to include in their portfolios:

  1. Is it adding diversification?
  2. Does it provide growth?
  3. How volatile is the investment?

The average SMSF portfolio investment allocation gives us a starting point to assess a portfolio on the bases of diversification, growth and protection (see graph 1).

Graph 1: SMSF asset allocation as at March 2016

Source: ATO: Self-managed super fund statistical report March 2016

Within the average portfolio, the majority of assets are held in cash, property and direct Australian equities (72 per cent). The ATO data doesn’t detail the nature of the managed fund investments, so they could be in any asset class. The other category includes limited recourse borrowing arrangements, debt securities, overseas shares (less than 0.3 per cent of the average SMSF), unlisted shares and more. Even if all of the managed fund investments were in overseas shares, the allocation to Australian listed shares would be almost double the exposure to overseas shares.

Dig deeper and ask questions

Cash (26 per cent weight)

The Reserve Bank of Australia cash rate is currently 1.5 per cent. The bond market has a 1.9 per cent yield on 10-year bonds. If the Australian economy fails to rebalance into new sources of growth after the resources boom, then interest rates will stay low for a long time.

The expected return of cash and term deposit investments in Australia is currently around 2.5 per cent. Not much to expect from returns, however, cash is liquid and safe. Its volatility is minimal. Cash has a role to play for liquidity and protection, however, it’s not much of a return source.

Property (17 per cent weight)

The Australian property market has produced solid returns for many years, so it is easy to understand why it makes up a large proportion of SMSFs. Because there is no listed market where daily prices are created for property, there is no daily price volatility that investors feel. It can give the illusion that property is less risky than it really is. What matters for property returns in the future are demand and supply of property, and the strength of the Australian economy and how it creates employment. An increase in unemployment would put pressure on the property market.In the 10 years ending 31 December 2015, Australian residential investment property was the best-performing asset class at 8 per cent a year. These returns will be difficult to repeat. Independent research firms and investment banks are forecasting cooling property markets, particularly in Sydney and Melbourne over the next two to three years. BIS Shrapnel forecasts negative returns over the next three years in apartments across all major Australian cities, except for Brisbane.

Graph 2: GICS sector exposure 2006-2016, S&P/ASX 300 Index

Source: Bloomberg Finance LP as at 30 September 2016

Australian equities (29 per cent weight)

The Australian equity market has evolved over the past 10 years from one dominated by banks and miners to one just dominated by banks. Banks nowmake up around 27 per cent of the ASX 300. They are very popular with SMSFs, due to their high dividend yield (currently around 6.1 per cent).In addition to banks, the most commonly held stocks by SMSFs are other large blue-chip companies with strong dividend yields.

Here, we address the characteristics of the concentrated blue chips in the form of the ASX 20 leaders and the state of dividend yield in the Australian market.

The roaring or snoring twenties?

The ASX 20 is even more skewed than the broader market index, with 11 out of the 20 constituents being within the financials sector, making up 54 per cent of the weight.In terms of fundamentals, as well as performance, these largest names have been underperforming of late. Earnings expectations for the ASX 20 have been declining, and while the rest of the market has seen an uplift this year, the mega-caps have hardly moved.

Considering investments outside of the blue chips is vital in providing opportunities for maximising returns in a low-growth world. While interest rates are low, the Australian banks may not be the best exposures for investors in the next few years. While the supermarkets are under intense competition from foreign competitors, their ability to churn out the returns of previous years may be limited.

Equity income — not all equal

On a cash basis, the Australian equity market is the highest yielding in the developed world and for Australian resident investors, imputation credits add a lovely cherry on top.The perceived stability of Australian dividend income could lead some investors to think of the market as being almost bond-like, a potentially dangerous misunderstanding. Equity prices are far more volatile than bonds. Also, unlike bond coupon payments, dividend payments are not fixed and can change at any time.

In the past five years, company payout ratios have climbed to very high levels in aggregate (from 55 per cent to 75 per cent), while dividend yields have remained around the same (4.5 per cent to 5 per cent). This reflects a period when companies generally held their dividends fixed while earnings fell. Earnings need to improve to sustain dividends in the Australian market, as payout ratios cannot increase much further, and probably need to come down.

Trying to make the most of dividends and franking credits while at the same time managing a smooth trajectory of total returns requires additional considerations, including:

  • other measures of valuation,
  • sustainability of the dividend, which is linked to the quality of the company (for example, leverage and ability to generate internal growth),
  • forecast earnings of the company, and
  • expected volatility of the company’s share price.

Diversity, growth and protection

While cash plays an important role in providing liquidity and is a highly defensive asset class, it is not an engine of growth, particularly in the current macro environment.Property is an asset class that has had strong returns over the past 10 years, but may not be as successful in the future. In addition, SMSF holdings are generally concentrated to one or two assets and are not diversified.

The Australian equity market has only limited exposure to new sources of growth outside of banks, supermarkets and mining companies. In order to gain exposure to these investments, the average SMSF should probably reduce exposure to Australian banks and consider diversifying into other parts of the Australian market and/or increasing exposure to offshore investments in markets with better growth prospects.

Both are viable options, but remember to think carefully about how to manage the currency implications if you decide to increase your offshore exposure.

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