Taken from then article in Financial Review titled Dual SMSF investment strategy that ticks all boxes by Tim Mackay Sep 23, 2019
The approach to diversification by SMSF Trustees needs to be flexible whilst still acting as a benchmark for your auditor to ensure your fund is meeting its investment requirements.
In September 2019, the ATO sent a letter to many SMSF trustees asking: “Is your SMSF investment strategy meeting its diversification requirements?”
This sent an element of panic amongst SMSF trustees who are predominantly invested in a single asset such as an investment property. If you didn’t receive this letter then the ATO is probably satisfied that you have:
a) an investment strategy;
b) that you know what the diversification requirements are; and
c) that you meet those diversification requirements.
Every SMSF must have a documented investment strategy. As a Trustee you will have signed the trustee declaration confirming you have one. It’s also important to keep this strategy up to date.
An investment strategy should document considerations relating to:
a) investment risks;
b) likely returns you seek;
c) liquidity (how easily you can sell investments);
d) the need for insurance; and,
e) the fund’s approach to diversification.
“Diversification” is a risk management strategy that mixes a wide variety of investments within a portfolio. If a portfolio is constructed of different kinds of assets it will, on average, yield higher long-term returns whilst also lowering the risk of any individual holding or security within the portfolio.
Diversification strives to smooth out unsystematic risk events in a portfolio, so the positive performance of some investments neutralizes the negative performance of others.
A SMSF investment strategy needs to meet two different objectives.
1) Your auditor needs to verify that your SMSF has met the conditions of your investment strategy every year, and
2) you want a documented SMSF investment strategy that gives you direction with flexibility and that meets the rules.
The ‘easy way’ is to document the asset classes your SMSF can invest in (for example, cash and cash equivalents, fixed income, property, Australian equities, international equities and alternatives), and specify an allowable range of 0 to 100 per cent for every asset class!
However, such a wide range gives no practical investing direction and would likely fail the scrutiny of the regulator, the ATO.
So what if instead you develop a practical, useful investment strategy?
Let’s assume your SMSF has a balanced growth profile with a 70:30 split between growth and defensive assets.
You could use typical ‘benchmark ratios’ where a specific range is set, for exampple:
i) cash and cash equivalents 3 per cent;
ii) fixed income and term deposits 27 per cent;
iii) property 14 per cent;
iv) Australian equities 28 per cent and
v) international equities 28 per cent.
Then you could give yourself about 10 per cent leeway for each asset class.
Whilst these are well-defined targets that enable good investment decision making and would indeed allow you to objectively compare your asset allocation over time, independent of emotions and market volatility, they may cause a legal issue for your SMSF and auditor.
Here is why:
If market conditions or your own circumstances change, forcing you to switching entirely to cash to protect your fund, or if you are a business owner wanting to buy a property using 95% of the SMSF capital you may be acting beyond the range of the documented investment strategy.
Your auditor would not be able to verify then that you have met the fund rules at all times.
A conflict may exist between wanting to create flexibility and still maintain sound investment direction.
This could be resolved by having two strategies.
a) A formal document that gives you maximum flexibility to act decisively in the members’ best interests and, within it,
b) a more detailed asset allocation exercise that you undertake twice a year where you do the detailed comparison.
While it may be a bit more work, it solves the conflict that trustees face.
And on the subject of investment property in the SMSF…
The vast majority of recipients of the ATO’s, letter hold a concentrated exposure to a single leveraged property and not much else; it’s not people holding 100 per cent cash. So the problem is less diversification and more the type and risk of the asset.
As a trustee, you must identify the risks created by asset concentration and have a documented Plan B if things go wrong. In giving this warning, the ATO has essentially covered itself should things go systemically wrong in this area. Trustees should therefore do the same with their own documented SMSF investment strategy.