Think your SMSF's asset allocation is spot on? Use the ATO letter to some funds as a reminder to revisit your strategy.
When you are the trustee of your own self-managed superannuation fund (SMSF), a letter from the tax office raising the possibility of a breach of rules and the potential of thousands of dollars in fines understandably gets your attention.
So it was not surprising that when some SMSF trustees and their accountants started receiving letters this month about the potential for fines for failing the diversification requirements within their fund’s investment portfolio, it sparked considerable public commentary.
Some of it bordered on outrage the tax office was trying to intervene in how SMSFs were being invested, overlooking that it was instead a reminder to comply with existing rules.
Far from being affronted at the tax office letter, the SMSF trustees – about 18,000 of them – should regard it as a flashing red light about the risk level within the portfolio to prompt a professional review.
Much of the commentary has focused on what a trustee needs to do to comply with the tax office requirements, along with clarification around the regulations the ATO is responsible for.
Compliance is important and the rules for setting – and documenting – a fund’s investment strategy need to be understood. But what is arguably more important is to understand the underlying reason for the tax office to send a trustee a letter in the first place.
The ATO says it sent 17,700 trustees a letter because tax records showed “these SMSFs may hold 90 per cent or more of funds in one asset or a single asset class”. Moreover, as the public commentary kicked up, the ATO clarified that 98 per cent of the funds contacted owned a property with a limited recourse loan financing arrangement in place.
So not only did the funds typically only invest in one asset – generally a property – but they had borrowed to buy it. Funds in this category undoubtedly are both in a small minority and in the high-risk category compared with the majority of the 560,000 SMSFs with more than 1 million trustees holding $750 billion in assets.
So the ATO is doing this minority of trustees a service by calling out the high level of risk involved – and the strong possibility that property spruikers have been involved with the set-up of the SMSF and property sale.
But the wider commentary may have broader benefit within the SMSF ecosystem if it prompts trustees, accountants and financial planners to review investment strategies of their SMSF portfolios through the lens of diversification. If the letters result in more SMSFs reviewing their portfolio and thinking about whether they are adequately diversified, that will be a positive outcome for the entire sector.
Some trustees may well be wondering why all the focus on diversification – or perhaps even more fundamentally, what is the meaning and value of diversification?
Diversification in simple terms is about spreading your investments across a range of asset classes to spread your risk. The value of diversification is that your portfolio should be less volatile than if it is concentrated in, say, a handful of Australian shares or – in the cases targeted by the ATO – a solitary property investment.
But to be effective a portfolio needs to be diversified both across the major asset classes and within each asset class.
The amount SMSFs allocate to overseas assets is a good case in point.
Data from research house Investment Trends and asset allocation data published by the ATO have, over many years, consistently highlighted the relatively low levels of SMSF investment in overseas shares when you compare SMSF portfolios with professional institutional investors.
Investment Trends has worked with Vanguard for the past decade to understand the investment approach of SMSF trustees. The latest edition of the research published in July surveyed almost 5000 trustees and specifically asked about both the levels of diversification and where trustees were intending to invest.
Expected to increase
The Investment Trends research says SMSFs allocate only 11 per cent of their total portfolio to international shares. But this is changing according to this year’s trustee responses, with overseas exposure expected to increase to 16 per cent in the next 12 months.
There are many sound reasons why SMSFs have a strong home-country bias in their share portfolios. And when you look around the world, investors naturally have a bias to their home markets. This is true in the US, UK and Japan.
We saw the power of the franking credit debate during the recent federal election, so tax impacts can be powerful influences – as well as the cost to invest in overseas markets and currency risk.
Cross-border investment products like ETFs, which have developed over the past decade, have a role to play as they have made overseas markets much more accessible and at significantly lower cost.
According to the Investment Trends research the three reasons that stop trustees investing more in overseas assets is lack of knowledge about overseas markets, currency risk and what to invest in.
The diversification debate among SMSFs is not going to go away. But unlike the small group of trustees targeted by the ATO, the majority of SMSF trustees are inherently conservative with their investment approach and their growing challenge is satisfying their need for advice on reviewing their portfolios and selecting investments.
By Robin Bowerman is head of market strategy at Vanguard Australia.
19 September 2019