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Clime time: Asset allocation decisions for SMSFs

Asset allocation (AA) is the process of constructing an investment portfolio among different asset classes, such as shares (domestic and international), bonds, property (listed REITs and direct), fixed interest securities, cash etc. The goal is to create a diversified portfolio that matches appropriate risk with appropriate returns for that risk. By investing in a variety of assets that are not closely correlated, investors can potentially earn fairly predictable returns over a period of say five years than if they were to invest in just one asset class.

SMSF trustees must understand the level of investment risk that the SMSF beneficiaries should be or are prepared to accept. An assessment of the appropriate target rate of return from the portfolio – noting potential capital gains and income – can then be made. The return should consider the benefits of compounding from full reinvestment (during the accumulation stage) or part reinvestment of the income (at pension stage).

Guidelines for asset allocation

Some key guides that I would encourage trustees to follow are:

  1. A short-term focus on returns should be avoided unless the beneficiaries are very elderly;
  2. The rate of return target (per annum) should focus on at least five years duration noting that over the longer term, economic growth is assured;
  3. AA should be dynamically reviewed as economic events or observations are noted – in particular bond yields need to be monitored;
  4. The AA analysis and assessment is best undertaken with the help and counsel of a qualified financial advisor, who can act as both a sounding board and a guide for an SMSF trustee.

The design of asset allocation for an SMSF starts from an understanding of a ‘balanced’ portfolio. In my view, a balanced asset allocation weighs equally to growth assets and to capital stable income-yielding assets. However, I acknowledge that there is no established or agreed industry position on what constitutes a balanced portfolio.

The proposed or advised AA moves from balanced based on risk adjustments so that a ‘conservative’ AA is created by weighting the portfolio to lower risk, capital stable and/or income assets. Alternatively, AA will move towards ‘growth or aggressive’ by weighting to higher risk, more volatile equity-type assets.

My table below is a general advice table for an SMSF, and readers should note that it has only one variable input – the age of the beneficiary. The outputs of the table (projected 5-year returns that include franking) simply suggest that a beneficiary will normally seek lower risk and accept lower (but more stable) returns as they grow older.


Source: Clime Asset Management

Clearly risk analysis requires more than a reflection of age. A comprehensive analysis considers a range of other issues (personal circumstances) that include health, non-super assets, home ownership and a desired quality of life (running expenses), dependents, and even psychological make-up. If exposure to volatile assets is going to keep someone from sleeping well, perhaps it should be avoided! Nevertheless, the table does provide an insight into how prospective investment returns change with asset allocation.

As noted above, the total targeted returns are expected to be generated from income and capital gains over a five year projection. As noted earlier the allocation to asset classes and the expected returns should be dynamically monitored. Changes to expected returns from the tailwinds or headwinds generally caused by actual or predicted bond yield movements will affect AA. Bond yield analysis sets the basis for determining the desired returns from assets and thereby the entry prices for acquiring assets.

What follows are my current views on the influences to asset prices, including the dilemma of rising long-dated bond yields, why they will probably rise further, and the effect this will have on asset prices.

What could affect asset returns

From the table above readers will glean that the main asset classes that I focus on are as follows:

Growth with income
- Australian and international equities plus listed REITs

Growth and income
- Direct property

Income
- Bonds
- Corporate debt
- Mortgage backed securities
- Hybrids

To begin, context is important. Where have we been?

Asset markets are emerging from a decade of rampant bond yield manipulation undertaken by the world’s largest central banks. Quantitative easing (QE) was the tool utilized by central banks.

In the main, central banks effectively printed money, targeted a particular bond yield/s in markets and then intervened by secondary market purchases to attain that yield. Over time, central banks became the largest owners of their government bonds. For instance, in the US, the Federal Reserve owns about US$7 trillion of bonds out of the approximate $30 trillion on issue. In Japan, the BoJ owns around 50% of all Japanese government bonds.


Source: RBA chart pack

The manipulation of bond yields allowed governments to run large fiscal deficits, avoid fiscal discipline and grow government debt with a low cost of servicing the same. Fiscal largesse had become a universal policy setting across the US, Europe and Japan, with its sustainability not questioned. Even now, there is scant regard given to it, but it will in time be reflected by higher bond yields unless central banks intervene again.

Readers will recall that for sustained periods over the last 10 years, Japanese, German and Swiss long dated bonds traded with a negative yield. Poorly-rated bonds issued by the Italian, Greek or Spanish governments (for instance) often traded at yields below the highly-rated Australian bond. During the pandemic, US and Australian long-dated bonds traded at yields below 1%.

The world bond market passed through a sustained period – after the GFC – where bond yields were not affected by the normal yield determinants that include:

  1. observed inflation and the risk of future inflation,
  2. currency risk for non-domestic buyers; and
  3. default and/or credit rating risk of the issuer.

Effectively, QE blew away all of these market pricing influences which are fundamental to sober valuation metrics. Thus, the so-called but vitally important ‘risk free’ return was debased and this affected the price of all asset classes.

It is clear that bond yields were not driven by the open or free market. Whilst there were willing buyers and sellers meeting in the bond market to trade their positions, the daily pricing of bonds was dictated by central banks. Today, that is still the case in Japan, but in other major economies central banks are indicating that they intend to reduce their influence over bond yields.

In effect, QE is moving to QT (Quantitative Tightening) whereby central banks reduce their bond holdings by allowing them to mature (redeem) and by not reinvesting the proceeds, or by selling them. The start of QT in the US is illustrated below, and the same monetary policies are being reflected across Europe. QT in Australia has slowly begun and it will have a significant influence on the bond market from 2024 onwards if the RBA begins to offload the majority of its bond holdings.

QT will add to the supply of bond issuance by governments and more so if governments do not concurrently bring their fiscal deficits back into order. The effect of a seemingly endless supply of bonds means that bond prices will be under pressure and yields will likely rise. This explains why US 10-year bond yields are beginning to rise even whilst measures of US inflation decline. I expect a similar scenario to play out across European and Australian bond markets.

How higher yields may affect asset allocation

Rising bond yields mean that the ‘risk free rate of return’ or the ‘risk free investment hurdle’ will lift and be a headwind for the pricing of all assets in the coming few years. This leads me to the following conclusions for both AA and assets prices over the next year:

1. Long dated bond yields (past five years) will continue to rise leading to capital losses that offset higher yields.

2. Shorter dated bonds (maturity of less than two years) are preferred as they currently match or exceed expected inflation and the risk of capital loss (via market prices) is not high.

3. Rated corporate debt is preferred to bonds as the repricing of long-dated bonds flows through. Staying short in maturity is desirable (up to three years). Mortgage-backed securities and hybrids are already seeing higher running yields and will be weighted into diversified portfolios as a core income generator.

4. Cash rate settings will remain elevated for longer than generally expected. Whilst cash rates in the US will likely fall during 2024, the same cannot be expected for Europe or Australia.

5. Equity P/E ratios will moderately decline with bond prices, so investors need to focus on companies that will grow earnings greater than and offset P/E compression. This will be difficult (short term) as economies slow with tight credit conditions being maintained over the next year.

6. Importantly, the longer-term growth outlook for Australia remains positive and far superior to Europe. The current weak AUD reflects negative “real” cash rates that won’t reverse until mid-2024. This suggests that a re-weighting to Australian equities from international equities or a currency hedge should be considered at some point early in 2024.

7. Rising bond yields will lead to a lift in capitalization rates for property with the commercial sector remaining under pressure. Non-discretionary retail (suburban shopping centres), industrial and agriculture will also experience cap-rate compression but offer better growth to offset this and particularly taking a five-year view.

AA analysis should not be dogmatic, and we must always consider what could go wrong with the forecast of bond yields or the risk free rate of return.

In my view, the key risk to the above view is the potential for the reintroduction of QE, leading to the reinstatement of bond price and yield manipulation that supports the servicing of government debt.

I suspect that there will be a bond yield level set by central banks in each major economy at which they will act to protect the financial viability of their governments. A burgeoning interest bill flowing from a bond market that panics has the potential to destroy a government’s fiscal policy and create economic calamity. It will be avoided at all costs and so we must monitor whether QE returns, or QT slows.

 

John Abernethy is Founder and Chairman of Clime Investment Management Limited, a sponsor of Firstlinks. The information contained in this article is of a general nature only. The author has not taken into account the goals, objectives, or personal circumstances of any person (and is current as at the date of publishing).

For more articles and papers from Clime, click here.

 

13 Comments
June
August 28, 2023

Well done John and thanks for your frankness. We also like to keep it simple in our SMSF with ASX shares, Hybrids, TD's, some Global Infrastructure Bonds. No Bitcoin or alternatives etc., but we do have listed and unlisted REIT's, although winding those down as the Trusts mature. I'm anticipating our net return to 30 June 23 to be around 15% when all reports are in. We even managed a small positive return in the last year when most retail/industry funds' returns were negative. But, on the flip side, we put a lot of time into our SMSF and, as we age, will be mindful of when it's time to wind up the Fund.

Guy Mudie
August 27, 2023

It's hard to make a case for bonds when I can get 5.2% on a term deposit ranging from 1 through to 5 years.
Easy to purchase with zero risk.
Yes, there's a possibility of some capital gain as interest rates fall but there's still a risk factor which does not apply with a term deposit.
Do retirees really need to take on that risk?
Keep it simple.

AndrewR
August 26, 2023

Thanks for this article John. As a new retiree, I set aside 5 years of living expenses readily available in cash or term deposits. The remaining funds are in growth assets. The cash buffer is topped up from asset earnings or sales when opportune or necessary. The asset allocation percentages are whatever they are based on this. I have found this simple approach to works for me. The only thing to decide is the size of the cash buffer ie 2, 3, 4, 5 years of expenses, which vary from person to person, and how to allocate the growth assets.

John Abernethy
August 27, 2023

Thank you Andrew,

Just some thoughts which is not advice.

Just monitor the returns that you are receiving on cash ( presumably term deposits) because the allocation of 5 years pension represents a 20% asset allocation.

If TDs are yielding 4%, then the contribution to total portfolio return is 0.8%. This means that if you are targeting 8% total return (for your fund) then the remaining 80% of assets needs to target a return of 7.2% pa representing a 9% return on 80%.

Having available cash makes abundant sense in retirement, but note the affect it has in diluting total returns.

Simon
August 27, 2023

Spot on Andrew. Absolute amounts set aside in cash (if able to do so, as most SMSF investors can) not percentages.

Graham W
August 25, 2023

Superannuation trustees should consider their super and non-super investments to get their AA right. I would also include the value of the family home which is often of considerable value. So, in my opinion direct property in a super fund is not a good idea. A retired couple with a million dollar house and a million in super already have a 50 % asset weighting to residential property. Other investments like cash ,term deposits, dividend paying shares and ETF's are far easier to transact and value.

John Abernethy
August 25, 2023

Hi Graham,

Thank you for your comment.

I covered many of your points in the article and you are absolutely correct that non super assets must be considered in a proper AA model. But we must differentiate between a residence, non super investments and particularly property investing.

I do suggest that SMSF trustees understand the role of a residence and the role of an investment in property inside a SMSF.

Whilst owning a residence is an essential pillar of retirement policy ( super , home , government pension ), the home does not generate retirement income where as investment property ( direct or listed ) does.

Home ownership saves negative income ( rental expense ) in retirement and therefore lowers the cash outflows of the cost of living. So it is vitally important.

Property investment generates substantial and growing income flows into a superannuation fund. Income flows can be reinvested ( compounding returns in accumulation) or utilised as cashflow to pay pensions.

Non residential property income returns are substantially higher than income returns from a residential property investment asset when considering investment in the property asset class. Residential property investing requires significant leverage and access to tax breaks that greatly changes its true risk profile.

I prefer and have personally utilised direct property opportunities with specialist managers. Investments in suburban retail shopping centres, industrial property, agricultural and tourism have performed well over the last decade - with growing levels of income and capital gains.

I prefer “closed end direct property” with a term of at least 7 years. These funds pay monthly income from the rentals received. The ultimate exit is advised by the manager - some sooner than 7 years and some slightly extended to generate the best IRR.

The issue for a SMSF trustee is to review the underlying asset, the quality of the manager, the tenants and the the opportunity of the asset inside the cycle. Property actually has many characteristics of equity investments.

When I look at property investing inside and outside super I do consider my home differently. It is owned for life style, saves rental outflows but I acknowledge the possibility that it could be used later in life for a capital drawdown need ( eg downsizing or health emergency or old age)

Obviously the house ( or it’s value) is an asset
that most of us want to pass to our children and grandchildren.

However, the significant cash needs in late old age must be acknowledged and a “pension” draw fund that has run for say 25 years may deplete if not appropriately structured with growing income streams that match ( at least ) inflation. That is what a AA discussion is about.


Jack M
August 25, 2023

Thanks for the added detail, John. On your comment "I prefer “closed end direct property” with a term of at least 7 years.", I also liked these investments for the income and eventual termination of the trust, but I had a poor experience with a shopping centre in Griffith. It was good for a few years, all as in the prospectus, but then a rival shopping centre opened nearby. Much of the traffic and stores moved there, and the trust was terminated at a loss. So the merit of the asset is still the first consideration. I'll bet a lot of closed end office trusts will struggle now to find a buyer.

Denial
August 25, 2023

Unless you have an adviser executing an auto AA on your behalf, I can't really see the point of discussing this in such precise terms. Yes a typical SMSF Trustee will have an allocation to certain asset classes other than just direct ASX share but will not generally be obsessed with their AA to such an extent.

Isn't the key point that SMSF should continue to diversify across asset classes to limit the potential capital drawdowns when paying an income stream rather than searching for the mystical efficiency frontier??

I get a kick out of reading Retirement Income strategy marketing material from most of the industry players. I have no idea still who it's supposed to be pitched at given it goes over the head of most of the people inside the industry.

Dudley
August 25, 2023

"matches appropriate risk with appropriate returns for that risk":

More cash than likely to spend and required cashflow less than age pension then appropriate risk is none beyond hyperinflation?

CC
August 24, 2023

I believe alternative assets ( private equity funds, private credit funds, long - short equity funds and hedge funds, maybe a bit of gold ) also have a role and I prefer approx 10% in alternative assets.
I much prefer cash and term deposits over bonds for fixed income especially now that interest rates are no longer ridiculously low.
30% in direct property ( not REITs ) is far too high given the low liquidity and most people already own property outside of Super.

Simon Taylor
August 24, 2023

Why this obsession with bonds? Hard to purchase, complex to understand (yield vs coupon), minimal rates and a whole lot of challenges and uncertainty as outlined. For the Australian SMSF or investor, having a quantity of cash sufficient for a few years of income, without selling stocks; it can be easily be spread across term deposits of different maturities which are easily to understand and to access for retail investors. Maybe some corporate debt ETFs or Funds for those who want complexity and higher returns. Easy to see why sound large cap shares paying good fully franked dividends are so popular! And for Australians with investments in property outside of super, a weighting of 30% inside super seems nuts ... to me at least.

CC
August 24, 2023

Most people buy bond managed funds or bond ETFs rather than individual bonds but I agree with your sentiments that cash and term deposits are easier.

 

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