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Portfolio defence without sacrificing returns

Defensive assets smsf portfolio

Defensive assets can not only reduce risk in an SMSF portfolio, but can also be a significant income source.

Defensive assets, such as cash and bonds, generally produce lower returns than growth investments, such as equities, over time, but can be useful for mitigating risk and generating income in an SMSF portfolio.

“It’s important to have defensive assets to provide a stable income and liquidity so the investment can be easily accessed,” Industry Fund Services head of technical services and advice enablement Craig Sankey says.

SMSFs with members approaching retirement commonly increase their defensives exposure to ensure they can pay pensions and protect the fund from capital losses.

“Some assets can go up and down, boom and bust, and that’s not appropriate for some people, especially in retirement,” Sankey explains.

Lower returns

The challenge is that managing risk by including defensive investments comes at a cost to returns, IFM Investors chief economist Alex Joiner says.

Cash and term deposits are the most popular defensive investments held by SMSFs, with around 20 per cent of all SMSF assets allocated to savings products, according to ATO statistics from December 2020.

Cash and term deposits are easily accessible and pose very little risk to the principal value, but Joiner says the Reserve Bank of Australia’s official cash rate is unlikely to rise much above its current rate of 0.1 per cent before 2024.

Government bonds, the other mainstay of defensive portfolios, are also delivering low returns. Australian 10-year government bonds were yielding just 1.7 per cent annually in May 2021, down from a yearly average of around 5.5 per cent through the early 2000s.

“There has been a structural decline in bond yields, so that means there are just not the returns that we used to get,” Joiner observes.

Corporate bonds may offer higher returns, but Sankey suggests SMSFs considering such investments need to understand the underlying assets.

“You have got to be aware that when you take on high returns, you take on more risk. Higher-yielding investments are probably not as defensive as some other fixed interest investments,” he warns.

Risk-managed income

To manage risk while seeking to maximise income, SMSFs can diversify their defensive investments.

“Diversifying within the defensive assets gives your whole portfolio greater diversification, which means lower risk overall,” Sankey says.

In income-producing investments, diversification means not only buying a range of assets, but also buying investments with different time frames to avoid locking into low interest rates. SMSFs can achieve this by buying bonds with varying durations or investing through diversified exchange-traded funds or managed investment products.

Alternative income options

Sankey recommends SMSFs also look beyond the traditional asset classes.

“These days there are more opportunities for alternative types of defensives: assets like unlisted property and infrastructure that have growth and defensive characteristics,” he points out.

Many SMSF investors are attracted to direct residential and commercial property. Over 15 per cent of SMSF assets are held in direct property, ATO statistics show.

Rental properties are relatively easy for SMSFs to acquire and housing markets have recently experienced significant price growth. While stagnant rental rates have meant lower yields, investors have benefited from capital gains.

However, rental properties offer limited diversification benefits as few SMSFs hold more than one property.

Unlisted property funds or trusts offer greater diversity of underlying assets, as well as access to institutional-grade investments and professional managers to optimise investment performance.

According to Joiner, unlisted infrastructure also has both growth and defensive characteristics, and performance is unrelated to equity or bond markets, which makes it useful for diversifying portfolios.

“You certainly have the potential to bolster your returns. Returns are not highly correlated with financial markets and they are less volatile than financial markets. Those are the characteristics that someone wants in their portfolio as they approach retirement,” he says.

SMSFs can invest in unlisted infrastructure through managed investment products, such as managed funds or the Self-Managed Invest option Hostplus offers.

Including a variety of defensive assets in an SMSF portfolio helps to protect against losses and can bring extra income into the fund.

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