Leave the comfort zone

PORTFOLIO POINT: Loaded up on Australian shares and cash in your SMSF? As a trustee, you’re not alone. But take a peek at what you’ve been missing out on.

It is unlikely to be of any surprise that you (Eureka Report subscribers) are big fans of Australian shares and cash as asset classes. It’s what you know best and feel most comfortable with.

That’s partly personal interest. And it’s partly because of the wealth of information that is provided each week on what is happening in Australian equities by the Eureka team. And, over the longer term, that has probably served you reasonably well.

Australian cash interest rate returns, when compared to international interest rates, have been pretty good. Our nation’s relatively high interest rates have insured at least a slightly positive real return (after inflation and tax) in recent years. If you’d had your money sitting in bank accounts in some foreign countries, it would, literally be going backwards if you took into account inflation and tax.

But as Alan Kohler points out regularly, Australian shares have done two-fifths of three-eighths of not very much for a very long time. Even with dividends added back in, returns from Australian equities have been dismal for an extended period now. Taking a shorter time period, the total return for calendar 2010 was less than 2 per cent.

But “shares” are not a homogenous asset class. Just like “oils ain’t oils”, it’s true that “shares ain’t shares”. And bonds ain’t bonds. And property ain’t property.

So what about diversification? And as a SMSF trustee, you have a duty to consider diversification in your portfolio. Firstly, I want to show you what you might have been missing out on. Secondly, how you can get some of that action relatively cheaply.

Let’s look at the 12 months to April 30, 2011. (I’ll be using Vanguard index fund returns as the benchmark.)

In the 12 months to April 30, Australian shares returned 4.6%. (And that’s being generous. If I used the year to May 31, that figure would look significantly sicker.) Given that the dividend distribution over that time was 4.53%, the “growth” for the 12-month period was just 0.05%.

Cash returned a similar figure of 4.5% (for cash I have used a Macquarie cash product).

Meagre returns. Nothing to brag about. If you did better than that with your portfolio, then well done.

But if you only had Australian shares and cash for that 12-month period, your lack of diversification cost you significantly. If you weren’t invested with some diversification across all asset classes, then here are the sorts of returns you missed, for at least parts of your portfolio.

Table 1: Asset class performance returns for the year to April 30, 2011

What should that show you? Well, almost every asset class flogged Australian shares and cash over that 12-month period.

The two exceptions were unhedged international shares and Australian property securities. The reasons for both are the incredibly strong Aussie dollar. And if you’d like to know more about how you may be able to profit from a falling Australian dollar via unhedged managed funds, click here (1/7/09).

What it also shows is that if you had your super invested solely in Australian shares and cash, then there’s a very good chance that you underperformed anybody with a “regular” managed fund super account, which will have diversification across most, if not all, asset classes.

Diversification isn’t just about having a portfolio with a minimum of 10, 12 or 15 stocks and having a couple of term deposits and a high-interest online bank account. It’s about asset class diversification. (It’s also about diversification of timing, which is a topic for another day.) And you have a responsibility to do so, right there in your SMSF’s “investment strategy”.

It means probably having, but at least considering, other asset classes, including international shares, fixed interest and property. And not just domestic, but giving some consideration to international also.

I’m sorry to say, but the fact is that almost any managed fund super account probably outperformed the typical Australian SMSF (or those solely invested in Australian shares and cash) over the last 12 months, simply because of their diversification across other asset classes.

But how do you do you get that diversification, if you want to? It’s not like picking top performing international shares from Australia is easy, without the help of stock brokers who can trade internationally, who won’t come cheap.

If you just want simple exposure to those asset classes, the answer is index or managed funds.

But how do you do them? If you want low-cost pure index-like exposure, then there are a growing range of exchange traded funds (ETFs) that are available that can be traded like shares. The number of providers is growing. But there’s also the more traditional index funds, such as those provided by Vanguard and Blackrock.

How much should you have? Briefly, traditional investment theory says a “balanced” investor should have an asset allocation something like the following, but I’ve also include more and less aggressive asset allocations:

Table 2: Traditional risk-weighted asset allocations

That may be a significant, and potentially uncomfortable, shift for many SMSF trustees. And I’m not suggesting that you should rush out and do that. But the reason for diversification is to smooth returns – sometimes improve them and sometimes lower them. And any look at Table 1 will show you that if you were only invested in Australian shares and cash that you have suffered performance issues for more than the last 12 months.

(And with the usual disclaimers about past performance being no indication of future performance …)

So, if that makes sense, it becomes a matter of how. Do you like the feel of ETFs, which can be traded like shares on the market? Or would you prefer to use index funds direct from the manufacturer?

The advantages of platforms are the ease of access, switching funds and consolidated reporting. Going direct to the manufacturers will generally come with slightly higher cost for managing the money itself, but without the cost of a platform, which will usually run somewhere between 0.5% and 1%.

Now, what have you missed?

How might a “balanced” portfolio have looked for the 12 months to April 30, with the international portion hedged (unless you wanted to take currency bets)? Here’s table 3.

Table 3: Diversified “balanced” portfolio

It might not have seemed like a huge difference, but if you’ve got the “average” SMSF of approximately $1 million, you gave up about 3% in performance last year (7.414% versus approximately 4.55%)

Yes, you gave up about $30,000. Which would cover dozens of times over the cost of platforms, managed fund fees (even index funds or ETFs).

Then again, the situation might reverse next year. But for anyone who believes in diversification, it’s time to start considering a shift away from your comfort zone of Australian shares and cash.

*****

The information contained in this column should be treated as general advice only. It has not taken anyone’s specific circumstances into account. If you are considering a strategy such as those mentioned here, you are advised to consult your financial adviser.

Bruce Brammall is director of Castellan Financial Consulting and author of Debt Man Walking.