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Once again it has taken a major market correction to highlight the high (and sometimes extreme) levels of correlation between different asset classes. Where once it was assumed returns from different asset classes such as shares and bonds were uncorrelated – and sometimes they are during ‘normal’ market conditions – during times of stress all asset values fall.
Which makes it extremely difficult for self-managed super fund (SMSF) investors to find assets whose values move in different directions at different times, to help protect the portfolio’s returns.
“The list of unusual intermarket relationships is extensive, but diversification has become increasingly difficult to obtain. That does not, however, negate the long-term benefits of diversification. Over time, asset allocation decisions drive a high proportion of returns in a portfolio,” says Tony Davison, senior financial adviser at Pride Advice.
The current climate has been instructive about the power of genuine diversification, says Morgan Collins, senior financial adviser with Lane Financial. “During COVID, we’ve seen opportunities arrive in gold, credit markets and alternative strategies that can be used to mitigate downsides in equities and property.”
SMSFs that had been exposed to these asset classes would have likely performed better through this period than funds that had been overweight in shares and property.
It’s also worth noting ATO rules require SMSFs to be appropriately diversified. In 2019 the ATO sent letters to more than 17,000 SMSFs that hold 90 per cent or more of their investments in one asset class, advising them to further diversify in order to comply with SMSF rules.
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What does a well-diversified portfolio really look like?
Davison says despite market turmoil, what constitutes a diversified portfolio has not changed. “Many investors split their portfolio into two broad categories: growth and defensive assets. They invest half of their portfolio in growth asset classes like shares. The other half is in defensive assets like bonds and cash proxies.”
Within each of those categories, there should be exposure to a spread of asset classes such as international shares, Australian shares, property and real assets, and government and corporate bonds. “Exposure to an individual asset class subset should reflect a slightly more tactical or nuanced view. For example, you may wish to be underweight to Australian banks or property at any given time,” he says.
Collins says a well-diversified portfolio would ideally contain a mix of Aussie equities, global equities, property and infrastructure. It may also include exposure to defensive assets such as sovereign and corporate debt and some high yield fixed interest investments. “Depending on the capital available to the SMSF, diversification can come from exposure to real assets as well.”
Paul Bourke, a director of ID Accounting and Wealth Solutions, notes diversification provides opportunity. “A diversified investor has an opportunity to divest their cash into undervalued asset classes. A concentrated position does not allow for this flexibility.”
Additionally, it’s important to consider your assets outside super when ensuring your portfolio is truly diversified. “The mix must be right. So if you are overweight in one asset class outside of superannuation, you might wish to focus on other asset classes within your superannuation,” says David Hancock, a financial adviser from Montara Wealth.
The most common diversification mistake SMSFs make is still being over-exposed to Australian stocks, in particular banks. This is especially problematic at the moment, says Davison.
“In the last three years, a portfolio concentrated in Australian financials has underperformed the ASX 200 by close to 30 per cent. Investors usually try to defend this by citing attractive dividends and franking credits. But, as they are learning, this was a transient trend and dividends may be under pressure for up to five years,” Davison says.
The flipside of this is not enough exposure to assets outside Australia. “The rest of the world offers exposure to different companies and sectors. Another issue is that many SMSFs are sitting on vast amounts of cash. They could consider investing in a blend of Aussie government and investment-grade corporate bonds to address this,” he adds.
Bourke agrees it’s important to be diversified not only across asset classes but also within asset classes. “Holding a handful of Australian shares concentrated in the banks and Telstra is not diversifying within the share market. True to label diversification will spread risk within asset classes across many industries and sectors. But I see so many SMSF portfolios concentrated on two asset classes – property and cash. They then throw in a few blue chip shares and call it diversification.”
He says many SMSF funds are also not actively managed, which compounds the risks associated with a lack of diversification. “Trustees pick a handful of shares and call it diversification and don’t revisit or review those shares for many years. This creates skewing within the portfolio and potential risk. It can create issues with the investment strategy and create compliance problems.”
Davison says there is an easy solution to this challenge. “These issues can be overcome with a robust, strategic allocation to a core portfolio of diversified ETFs, coupled with a nuanced portfolio of bespoke, trustee selected assets.”
Another common mistake when it comes to diversification, says Collins, is using the fund to buy a single asset like a property. “There’s only a few good reasons to do this. You’re young enough to realise the long-term benefits of gearing you can’t do with other assets, outside of warrants. Or it’s a commercial property for your business and you are saving rent by paying your super fund instead. This can be corrected by ensuring you only go down this path when there is capital to diversify, or a high level of contributions to do the same.”
With markets in a never-before-seen paradigm, it’s critically important for SMSFs to properly diversify their assets. At the start of a new financial year, now’s the time to review the assets in the fund and assess whether it’s truly diversified, to right-size the portfolio for inevitable future shocks.