Diversification can be key when it comes to ensuring your SMSF is performing the way you want it to. But how do you know if your SMSF is sufficiently diversified?
The ATO could potentially impose an administrative penalty if an SMSF fails to meet the diversification requirements under regulation 4.09 of the Superannuation Industry (Supervision) Act (SISA). The ATO has reminded many SMSF trustees with 90% or more of SMSF investment in one asset class to provide evidence of investment strategy compliance, including satisfactory diversification, to their SMSF auditor during the next audit. While it’s vital to get professional SMSF advice that’s specific to your circumstances, let’s take an overall look at how investing across different asset classes such as cash, listed shares, property, and fixed-income bonds can help to diversify the SMSF.
Why is diversification so important?
When navigating the SMSF, it’s important to spread risk around so that if one type of asset doesn’t perform, you have other types of assets to help you reach your investment goals.
The performance of any investment is inexorably linked to cycles of growth and corrections which, historically, tend to play out over many years. For example, the Australian residential housing market has attracted investors throughout long periods of high capital gains but from time to time, investors with all of their capital in residential property might wish they’d invested at least partly in shares. However, it takes only common-sense to understand how suddenly cutting losses in the property market to invest everything in shares, which may then suffer a market correction, can result in what is called “chasing the losses” or effectively gambling with a reducing investment.
A non-diversified investment portfolio also creates more concentrated exposure to changes in legislation and ATO rules which may affect investment performance directly or indirectly. Using real estate as an example again, since an SMSF that owns one or several rental properties is no longer considered ‘being in the business’ of letting rental properties, according to the ATO, it is no longer generally tax-deductible to attend a residential investment property for inspection or maintenance purposes, even if the investor lives in Victoria and the residential investment property is in Queensland.
Many investors recognise the importance of asset diversification in their portfolio. Some choose to add liquid assets such as shares and bonds, thinking that there would be cash readily available if needed. Liquid assets could potentially help to pay for administrative expenses, income tax, and minimum pensions along the way.
The most important thing is that all advice received and decisions made for the SMSF should be specific to your own needs and circumstances. There is no such thing as one-size-fits-all advice concerning something so important and unique to the stakeholders as an SMSF – its structure, strategy, compliance, and administration.
The ATO checklist advises that the SMSF should have an investment strategy that considers all circumstances of the fund, including risk, diversity, liquidity, and the circumstances of members.
What does a diverse SMSF portfolio look like?
The diverse SMSF portfolio would typically feature a range of local and global assets. This could mean having a mix of cash and term deposits, fixed interest, direct property, and infrastructure investments, along with Australian and international shares.
Here are just some of the asset classes explained in simple terms:
Shares in listed companies represent just under 28% of all capital invested by SMSFs in this asset class (ATO September 2018).
Previously only available to large institutional investors, SMSF investors may now access these assets through managed funds and direct investment options. Infrastructure assets can be spread across several categories such as social, transport, and utility investments.
Real estate income/value is driven by rental prices and sales-market forces. The property category includes residential, commercial and industrial assets.
Fixed income (bonds)
Similar in concept to an IOU with interest, bonds are traditionally considered to be a reliable potential income stream. Bonds can be attractive to risk-averse investors and may feature in the diversified portfolio.
Many business owners and self-employed people decide to establish an SMSF so they can have direct control over the investments they’re making to provide for themselves in retirement through superannuation. It makes sense to diversify any form of investment, particularly with SMSF investment when the security of future retirement will depend on it.
If you’d like to know more about SMSF setup, compliance, and administration, call The SMSF Accountant today.