Diversification - Managing performance and risk
Sometimes referred to as ‘the only free lunch in investing’, diversification is used in the construction of investment portfolios to reduce risk and to provide liquidity.
By not having all the ‘investment-eggs’ of a SMSF in the one basket – that is, in the same or similar asset classes, the risk of a portfolio falling in value for an extended period or not being able to meet its commitments can be reduced or mitigated.
As different asset classes tend to perform differently at different times and even by different geographic locations, having a spread of investments over a range of asset classes can see stronger performing assets counter those that may be under performing at a point in time.
Why is diversification important?
It is a requirement that trustees have a written investment strategy, that gives consideration to the fund’s objectives of:
- meeting its investment outcomes – growth and income or both
- having liquidity to meet its ongoing regular obligations, such as paying members benefits, pensions for example and meeting its administration and operational costs
- being able to easily liquidate sufficient assets in a timely manner to cover an unforeseen event such as a member deciding to leave the fund and transfer their balance.
In planning and implementing the investment strategy, trustees need to be conscious of the risks of different asset classes and of different investments and investment styles available within asset classes, balancing both sides of the investment decision – reward and risk.
There are no ‘risk-free’ asset classes – even for cash and term deposits, risk could be defined as not receiving a return above inflation.
How can trustees approach diversification? In steps.
There are a number of considerations towards achieving diversification but at a high level it can be viewed in two steps:
- Asset allocation – what proportion of which asset classes the fund holds. Generally, this is not a ‘hard figure’ but a range within which trustees consider it appropriate for the fund to have exposure to each asset class for example ‘5%-10% in cash’ and
- Portfolio construction – which investment products or structures and styles sit within each asset class within the portfolio.
The extent of trustee’s knowledge regarding asset allocation is important, as getting the assets classes right, can have a greater effect on performance over the medium to longer term, than selecting the underlying investments.
Don't set and forget
Over time the fund’s actual asset class exposure will change. This can be driven by a number of factors, such as market movements (up or down), asset class cycles, growth in cash as a result of member contributions not being invested or income and contributions being invested into a well performing asset class at the expense of others.
Trustees need to review the fund’s position on a regular basis and decide if it is necessary to make changes to the portfolio by rebalancing.
Rebalancing may involve selling some investments that are overweight (outside the investment strategy range) and re-investing those funds into underweight asset classes.
However, this does not always have to be the case as rebalancing can occur over a period of time and not necessarily require assets to be sold. For example, by directing a higher proportion of the income or contributions to underweight asset classes or suspending any regular reinvestment plans to overweight assets.
If assets are sold, trustees need to conscious of the impact of any capital gains outcomes.
Given the importance of getting the asset allocation right, it may be appropriate for trustees to seek advice from an SMSF specialist, who can help with strategic guidance on what would be an appropriate asset allocation for the fund and its members.