This time, the tax office is just here to help SMSF investors

Mention the Australian Taxation Office to most people and they’re more likely to break out in a cold sweat than a broad grin.

Perhaps too many of us have a guilty conscience, but if we were to find an envelope from the taxman in the mail, our reaction would tend to be one of trepidation. Are we in trouble? Do we owe the ATO money?

If you’re an SMSF trustee, you might be in line for a letter from the ATO. But, to steal a slogan, they’re telling you to be alert, not alarmed.

This round of contact from the ATO is a friendly reminder of the benefits of diversification in your investment portfolio – coupled with a slightly more compelling reminder of your obligations as an SMSF trustee.

It’s sage advice and, apparently, a necessary prompt for quite a few SMSF investors.

The benefits of portfolio diversification should be well known to most but, in practice, they’re sometimes pushed aside for other considerations.

Still, it’s an enduring truth that lowering risk by spreading investments into different asset classes is a worthwhile strategy.

It’s by diversifying our investments that the risk of a downturn in any single market can be lowered, with a better investment outcome as the result.

Why the reminder?

The ATO has good reason to be concerned that not everyone seems to have received the diversification memo.

Alarmingly, it has identified almost 18,000 SMSFs which have more than 90 per cent of their investments in a single asset class.

Even more concerning is that most of these funds are using a Limited Recourse Borrowing Arrangement (LRBA) to finance their single asset.

This has prompted the tax office to warn investors of the potential dangers of such large exposures. Due to the regulations on LRBAs, many – if not most – of these SMSFs have borrowed to finance their asset, which is usually a property.

If there’s a large market downturn an SMSF could be in trouble. It’s this eventuality that the taxman is hoping to prevent.

Lack of diversification is common

Australian SMSFs are notoriously under-diversified. According to data produced by the ATO shown in the chart below, there’s very little allocation to global shares and bonds and an over-investment in Australian shares, property and cash in a typical SMSF portfolio.

This can create unnecessary (but easily rectified) risks that can potentially affect returns.

SMSF Asset Allocation

The ATO has also found that those SMSFs with a single property investment funded by an LRBA may be so under-diversified as to present a major concentration risk and to be in breach of the regulations under which SMSFs operate.

The tax office notes that nearly two-thirds of funds with LRBAs are worth less than $500,000 and 85 per cent of them are valued at under $1 million.

Almost half of SMSFs identified by the ATO have 90 per cent of their assets in a single asset class, often a property funded by an LRBA.  Since SMSFs are required to consider investment options to allow adequate diversification, it’s probably not ideal to have all/most of your SMSF in property, as that may then expose the SMSF to risks.

SMSFs with between $500,000 and $1 million are considered ‘small’ by the ATO, and its concern is that the risk of a single investment – especially one funded by borrowed money – creates an unacceptably high exposure of the fund to a downturn which could render it worthless.

Keen to avoid this, and mindful of the regulations intended to prevent these situations arising, the ATO is reminding investors of their obligations as well as the potential risks to their investments.

Helping protect against risk

The regulation to which the ATO is referring is Section 52B(2)(f) of the Superannuation Industry (Supervision) Act. Its most important requirement is that trustees develop and update their fund’s investment strategy.

A well-crafted investment strategy should hold diversification and portfolio construction front-of-mind, as these two aspects of a portfolio help to protect against the risk of any one asset class adversely affecting performance.

Lowering risk through diversification may also have the effect of boosting investment returns. Any investor’s goal is to increase return while at the same time reducing risk and it’s a diversification strategy which can help achieve this.

Funds which have large exposures to single investment classes are concentrating, rather than spreading, risk. This may be great when the asset’s value is going up but disastrous when it’s falling.

Growth assets should be factored in

To illustrate the opportunity lost by many SMSFs with low diversification and under-allocation to growth assets - such as global shares - we can look at the performance of a representative SMSF and a diversified growth fund, typical of those into which many non-SMSF Australians invest.

Using data collated by market research and data collection agency SG360, we can see the marked difference that investing with diversification in mind can have.

Value of $100,000 invested 10 years ago

 

This reinforces the message that SMSF investors looking to achieve an optimum result with risk management in mind should consider diversification within their fund.

So, rather than being dismayed by this particular letter from the ATO, take some time to consider your situation.

The benefits of a well-constructed portfolio are widely acknowledged and it’s something the ATO wants to be sure you understand.

Maybe it’s about time we got some good news from the taxman?

 

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About the author:

Angus McLeod is a 25-year veteran of the financial markets, having spent 12 years as an equity portfolio manager. He holds a degree in Economics, a master’s in Applied Finance, and is a CFA charter holder and a CIMA® certificant. Angus is a lecturer in the Master of Finance course at RMIT University.

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