Opinion

Is effective diversification possible for the SMSF investor?

By Greg Maclean
Global Head of Research, Infrastructure Sydney, Australia

The value of assets moves up and down (i.e. shows volatility) depending on market conditions at any point in time. By investing in assets with different characteristics (diversifying), you attempt to dampen out the impact on your portfolio of any individual asset price movement.

The degree to which asset prices move relative to each other is known as correlation. Assets with a correlation coefficient of 1 would move completely in sync. However, assets can also display negative correlations, which means they move in opposite directions. Negatively correlated assets are highly desirable for portfolio construction.

The classic bonds and equities portfolio was based on a long history of price movements showing that bond yields and listed equity prices were generally negatively correlated. This meant that losses in one of these asset classes could be offset by gains in the other, at least to a degree.

However, the GFC turned this comfortable situation on its head. When markets were in free fall, listed markets crashed together (their correlations approached 1). Consequently, apparently well-diversified portfolios failed to provide protection.

Since the GFC, equity markets have moved into greater alignment than before. For example, the correlation index between the US S&P 500 and the Australian S&P 200 Total Return indices, since March 2009 is over 0.85. Similar patterns can be seen in other equity markets. This means that simply investing in listed equities in different developed economies produces little in the way of diversification benefits.

Additionally, most government bond yields have been depressed to the extent that returns barely cover inflation. This means that their value as an investment for SMSF investors right now is questionable, irrespective of their correlation with equities.

For a long-term value investor, do these trends really matter? Unfortunately, I think they do. Active strategic management of portfolio allocations is still required. At the very least, the long-term investor clearly needs an alternative for bonds.
In response to these issues, many large institutional investors are actively increasing their allocations to real assets, particularly to real estate and infrastructure. They are attracted by the long-term secure cash flow aspects of these assets which are viewed as a good bond substitute.

Additionally, they provide a diversification benefit to portfolios as their valuation cycle is largely divorced from equity markets, resulting in low correlations and low portfolio volatilities.

For an SMSF investor, there are a number of difficulties in following a similar strategy.

Real assets are big-ticket items, often trading for hundreds of millions or billions of dollars. A diversified real asset portfolio (i.e. with stakes in numerous assets) is a struggle for even large wholesale funds, let alone an SMSF.

The assets are also illiquid. That is, they are not traded daily.

Most of us already have an exposure to real assets through the family home. Additional direct Australian property investments, through the SMSF, risk over concentration.

Consequently, I believe the most effective way for an SMSF trustee to gain additional real asset exposure is through investment in specialist unlisted property or infrastructure funds.

The advantages are:

  1. Such funds may invest in multiple assets across different asset classes and countries, therefore the fund portfolio may already be diversified;
  2. Reduced exposure to listed market volatility;
  3. Good and stable expected returns (post fees), fully hedged against currency movements; 
  4. Depending on fund, high levels of liquidity. That is, the fund covers the illiquidity risk.

Issues to be aware of are:

  1. The proportion of cash yield in the overall returns can vary depending on fund style. Some funds, particularly real estate funds, may give virtually 100% yield, while infrastructure funds tend to provide higher overall returns balanced between growth and yield. 
  2. While this strategy is a currently a good long-term option, conditions do change. It is important to re-assess asset allocations regularly.

In the context of my own broader portfolio, I have followed my own advice and am invested in an infrastructure fund. So far, I am pretty happy, as it has delivered better returns than listed markets (after fees) at very low levels of volatility. Consequently, I have no need for bonds and currently have a zero bond exposure. In effect, this single investment has largely replaced a traditional bonds and equities portfolio.

My fund is in drawdown mode but I prefer the high returns of an infrastructure investment even if it means that I have to draw down from the fund if required.

  • Diversification
  • Opinion
  • SMSF News

Important notes

While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

Cookies & Tracking on our website.  We use basic cookies to help remember selections you make on the website and to make the site work. We also use non-essential cookies, website tracking as well as analytics - so we can amongst other things, show which of our products and services may be relevant for you, and tailor marketing (if you have agreed to this). More details about our use of cookies and website analytics can be found here
You can turn off cookie collection and/or website tracking by updating your cookies & tracking preferences in your browser settings.