Portfolio diversification is one of the key tenets that underpins modern portfolio theory (MPT). Whether it’s an investment manager selecting bonds for a fixed income fund, a super fund investment committee determining the strategic asset allocations for members with different risk profiles or a financial adviser devising an appropriate investment strategy for an SMSF, portfolio diversification is an important element.
The importance of diversification was encapsulated in MPT, developed by Harry Markowitz and first published in 1952. Markowitz hypothesised that investors could design an ‘optimal’ portfolio to maximise returns by taking on risk – and risk could be managed through diversification, both within asset classes and, importantly, across asset classes.
The barbell
An analysis of SMSF portfolios indicates MPT has, to some degree, gone by the wayside. Recent asset allocation data indicates many SMSFs adopt a ‘barbell’ approach, with a substantial exposure to equities at one end of the risk/return continuum and a large weighting to cash at the other.
According to the ATO’s quarterly SMSF statistical report at end September 2017, the average fund had nearly half of its portfolio invested in equities and a quarter in cash and term deposits – of the remainder, an average of just 1 per cent was in bonds.
If you were to compare that with a professional investor, the asset allocation would look quite different. Using the Colonial First State FirstChoice Balanced Option as a yardstick, while nearly half of the portfolio is invested in domestic and global equities, it has a 22 per cent exposure to fixed income and less than 10 per cent allocated to cash.
The equities domination
Whether accumulating retirement funds or drawing down, growth assets are important. However, even a very well diversified equity portfolio can fall prey to investor sentiment and suffer from a market downturn. In such an event, investors with 50 per cent of their SMSF exposed to equity markets might experience sequencing risk.
Sequencing risk is the risk that the order and timing of investments is unfavourable. Volatility in markets and the order in which investment returns occur can make a substantial difference to the capital base once investors begin to draw on their retirement savings. If returns early in retirement are negative, then proportionately more capital is required to fund ongoing living expenses. This reduces the possibility of recouping losses over time.
Cash is not king
Although investors like the security of money in the bank, there’s a significant downside to this approach – longevity risk, or the risk of an investor outliving their savings. A recent study by National Seniors Australia found while people are aware they’re likely to live longer, they are resigned to outliving their savings – just 50 per cent had financially planned for a longer future. With rates now at their lowest since records began, cash investments barely keep pace with inflation; despite this, an average of 23 per cent of SMSF portfolios lay idle in cash and term deposits.
The under-represented bond
A diversified investment portfolio should include defensive assets, ones that balance exposure to growth assets such as equities and property. As a defensive asset, bonds can play an anchoring role in a diversified portfolio and in overlooking bonds in favour of cash and term deposits, investors miss out on the benefits bonds can bring to an SMSF portfolio:
1. An income stream
Bonds provide income from regular coupon payments, which are generally quarterly or half-yearly and occur on set dates. As a result, investors can accurately plan to match outgoings with the income they know will be received from bonds.
2. Capital preservation
Bonds can provide capital stability. At maturity, a bond’s face value is returned to the investor, which makes a bond an effective capital preservation tool.
3. Diversification of returns
As a defensive asset, bonds are not correlated with equities, and have a different risk and return profile. It’s this difference that provides the diversification benefit. While the prices of bonds will fluctuate according to interest rates and the economic cycle, historically bond prices have been considerably less volatile than share prices.
While investors can reap some of these benefits from a bond fund or exchange-traded fund, a direct investment in bonds will enable an SMSF portfolio to really make the most of a bond’s unique features. Direct investment in bonds can be challenging; XTBs – exchange traded bond units, traded on the Australian Securities Exchange – can make them more accessible.
As well as providing capital stability and a predictable and regular income stream, the defensive nature of corporate bonds – and therefore XTBs – will generally result in low or negative correlation with equities.
These attributes make XTBs a worthwhile consideration for SMSF portfolios to balance the risk/return profile and strengthen the portfolio by moving away from the barbell approach to asset allocation.
