Diversification and your SMSF: Why and how to do it

Diversification is a fundamental investment management principle designed to reduce the risks inherent in investing. If your SMSF isn’t properly diversified, it leaves you exposed to significant risk if a major investment or asset class performs poorly.

The theory behind portfolio diversification was first pioneered by Nobel Prize winner Harry Markowitz in 1952. His work illustrated how owning shares in different industries and countries – together with other asset classes – resulted in smoother overall investment performance without lowering returns. This approach remains the foundation of the investment strategies used by major institutional investors around the globe.

The rationale for diversification is assets that are similar (the technical term is correlated) due to being in one asset class, industry sector or country, have historically moved in the same general direction. This means assets within the Australian share or bond market for example, all tend to rise or fall at the same time.

By diversifying, you can avoid this tendency, as the pattern of returns for different asset classes tends to be different over time.

As you can see in the table below, shares performed strongly in the year to June 2023 while Australian bond returns and cash went backwards in real terms after taking inflation into account. Whereas all asset classes have beaten inflation over the long run.

Source: Vanguard Australia 2023 Vanguard Index Chart 

Although the theory behind diversification sounds complex, it’s simply the old adage, ‘Don’t put all your eggs in one basket’.

If your SMSF portfolio has limited diversification, the potential for losses is greater than if your money is spread more widely.

Combining different asset classes also helps smooth out your fund’s overall investment returns over time.

Diversification? That’s a fail for many SMSFs

Although investment experts encourage SMSFs to take a broadly diversified and risk-adjusted approach to their portfolios, an ATO data release in February 2023 showed a different story. At 30 June 2021:

• Cash and term deposits were the sole asset held by 6% of SMSFs
• 8% of SMSFs held all their investments in one asset class, consistent with results in 2019–20
• 46% of SMSFs with assets of $50,000 or less held all their assets in one asset class, compared to less than 15% of SMSFs with assets over $500,000
• 40% of SMSFs held 50% or more of their assets in either cash and term deposits or listed shares.

Although the data indicated limited diversification tended to be more common in lower balance SMSFs, and might increase as balances grow, there are still many funds that fail to adequately diversify their investment portfolios.

Diversification and the regulators

Diversifying your fund is not just a smart investment strategy, it’s also something the SMSF regulators expect to see.

ASIC considers adequate diversification a key part of running a SMSF. It requires financial advisers to discuss diversification with their clients and inform them “about the benefits associated with diversification”.

The SMSF rules also require funds to be appropriately diversified. In 2019 the ATO sent letters to more than 17,000 SMSFs holding 90% or more of their investments in one asset class, warning them to diversify or face an administrative penalty.

As the ATO website notes: “While you can choose to invest all your retirement savings in one asset or asset class, risks such as return, volatility and liquidity can be minimised if you invest in a variety of assets … Investing the predominant share of your retirement savings in one asset or asset class can lead to concentration risk.”

If your SMSF isn’t diversified, your investment strategy must document that you have:

• Considered the risks associated with a lack of diversification
• Thought about how the current portfolio meets your fund’s investment objectives, including your return objectives and cash flow requirements.

How diversification improves SMSF performance

Diversification is not just about following the super rules, it can also affect how much your fund members have in retirement.

The Understanding Self-managed Super Fund Performance, February 2022 study conducted by Adelaide University for the SMSF Association analysed returns from over 318,000 SMSFs from 2017 to 2019. This represented almost 56% of all SMSFs.

A key finding was SMSFs with more diversified investment allocations achieved higher returns across all the years studied.

The researchers found the least diversified SMSFs – those holding their entire super balance in a single asset class – recorded the lowest returns. SMSFs with more diversified portfolios – even slightly more diversified – all outperformed this group over the study period.

The researchers concluded the benefits of adding a second, third or fourth asset class were “strong and consistent” across the period 2017–19. Each incremental increase in the number of asset classes used by a fund (up to four asset classes) was associated with an improved investment return between 1% and 3%.

In reaching their conclusions, the Adelaide University researchers considered the performance impact of holding seven asset classes: cash and term deposits, listed Australian shares, listed international shares, listed trusts, unlisted trusts, limited recourse borrowing arrangements (LRBAs) and other assets.

Once an SMSF diversified beyond four asset classes (up to seven asset classes), its performance improved, but only marginally. SMSFs diversifying beyond four asset classes generated anywhere between 0% and 2% in additional return per extra asset class.

Where an SMSF held a high level of cash and term deposits in its portfolio, investment performance was lower compared to SMSFs holding only 10% to 20% in cash and term deposits.

This is a significant finding given the June 2023 Vanguard/Investment Trends SMSF Report shows over of a third of SMSFs are currently increasing their allocation to cash and cash products. Although cash reserves are a normal part of any investment portfolio, trustees need to carefully weigh their concern about current economic conditions against the potential impact on their fund’s performance.

What does a well-diversified SMSF portfolio look like?

While it’s easy to talk about diversifying your SMSF portfolio, there is no simple answer to what a diversified portfolio should contain.

Ideally, a well-diversified portfolio blends a mix of Australian shares, international shares, property, infrastructure, cash and fixed interest (such as bonds, sovereign and corporate debt).

Diversification should also be within each asset class to protect against the risk a single company, bond or property will perform poorly.

At a minimum, the fund’s portfolio should be split across a mix of growth assets (shares and property) and defensive assets (cash and fixed interest). This helps to reduce investment risk and deliver a smoother flow of investment returns.  

A well-diversified investment portfolio also needs diversification across geographic region and sector. By adding some international shares to the mix, your fund’s portfolio is not solely at the mercy of the Australian economy, as it is if you only invest in local shares.

The domestic share market is heavily concentrated by sector, with financials and resource stocks making up a significant percentage. Australian portfolios often rely heavily on the big four banks, which have served investors well over the years but pose a risk if the banking sector suffers a downturn. Also, if your SMSF only invests in Aussie shares, you miss out on many of the high growth sectors (such as health and technology), that are inadequately represented here.

By selecting a range of different sectors, countries and even regions within a particular asset class (such as Australian retail property, European residential and US industrial property), you can increase the odds different parts of your portfolio will hold their value if others drop.

Non-traditional assets such as unlisted infrastructure, institutional-grade local and international property and private equity can also be worthwhile inclusions. Although these assets are difficult to access for investors with smaller balances, an option can be to use managed funds or investment options offered by bigger super funds.

Several large industry funds offer SMSF trustees a wide range of non-traditional assets. For example, the Hostplus Self-Managed Invest infrastructure option provides access to major unlisted infrastructure assets and top investment managers. Other options include emerging markets, venture capital, private equity and credit alternatives.

Diversification strategies for SMSFs

Tip 1: Spread your investments across asset classes

• Spread your fund’s investments across a range of asset classes or invest in a diversified managed fund or investment option.
• Ensure your fund doesn’t allocate a large percentage of its investment portfolio to a single asset class (such as cash or property).
• Consider adding some non-traditional assets like private equity, venture capital, commodities, global bonds or infrastructure. Gold, for example, has a very low correlation with most other investment classes. Alternative assets can be accessed through specialist managed funds and exchange traded funds (ETFs).

Tip 2: Invest widely within specific asset classes

• Diversify both across and within asset classes. The Australian share market has 11 sectors and 24 industry groups, so select a broad mix of companies.
• Include a mix of different countries and regions within each asset class to protect against local economic conditions and political risks.
• Rebalance your investment portfolio regularly to ensure it your doesn’t drift from your established strategic asset allocation.
• Think about your entire investment portfolio, not just your SMSF. Review whether there is a big overlap in asset classes between your SMSF and your investments outside super.

Tip 3: Use different investment approaches

• Diversify on multiple levels within your SMSF. Consider using different investment styles and vehicles. Good diversification involves diversifying over time periods too, as some asset classes tend to perform over longer periods, while others provide returns over shorter time periods.
• Consider using both active and passive management for a particular asset class, or your entire portfolio.
• Choose a blend of investment managers who use different investment styles (such as value, growth or multi-asset).
• Use different investment vehicles. While investing directly gives your control, consider adding other structures such as ETFs, listed investment companies (LICs), real estate investment trusts (REITs), traditional managed funds (listed and unlisted) and property syndicates.

• Think about using techniques like dollar cost averaging. This means you are buying when the market is up as well as down, so your investment cost base is diversified over time.

• Select a mix of both growth and income focussed investments. Investing only for high income and dividends usually comes at the expense of capital growth. Growth and income investments also tend to perform better at different points in the investment cycle.