Portfolio Construction - Building a diversified investment portfolio

Once trustees of the SMSF are satisfied that the investment strategy they have developed is appropriate for all members, they will need to consider how to create a portfolio that reflects that strategy and which investment products they use to do so.

This is called portfolio construction and may result in putting together a range of different product types to build out each asset class outlined in the strategy document.

The type of investment products they choose may reflect their own knowledge of the asset classes they will include in the portfolio. For example, if there is a high knowledge level and comfort with the Australian equity component, trustees may choose to use a number of listed Australian shares. If on the other hand, they are less confident regarding the fixed income component, they may choose to use a professional manger to either put together a fixed income portfolio or invest in a packaged solution such as a managed fund.

If choosing a managed fund there may be other considerations such as:

  • Style – is the manager active or passive? Active managers seek to outperform a benchmark, while passive managers may track an index or benchmark.
  • Access – can the manager be accessed through an exchange, such as ASX or is the fund ‘unlisted’
  • Cost – the fees charged by a manager can have a number of components; two are:
    • Style – active management tends to be more expensive than passive and
    • Difficulty of the asset class – if the underlying assets are difficult to access or to manage, such as global equities as opposed to Australian shares, then the manager may charge more.

The costs charged by managers are usually embedded in the fund and deducted from its performance before any payment to investors. These costs are usually reflected as a basis points (bps) charge called a Management Expense Ratio (MER). A MER of 25bps is 0.25%.

Product types

Structures

  • Managed funds are open-ended unitised investments, where investment funds are pooled, with each investor having a proportional number of units based on their share of the fund. Being open-ended means that the number of units on issue can grow as more investors join and/or existing investors reinvest income earned. The size of the fund can change as the value of the underlying assets move (up or down). This is reflected in the unit price.

  • Listed Investment Companies (LICs) and Trusts (LITs) are closed ended investments listed on a stock exchange, such as ASX. Being closed ended means that the number of shares (LICs) or units (LITs) on issue at a point in time is fixed. The size of closed ended investment funds grow in a number of ways, for example, investors may choose to reinvest dividends or distributions or the manager may raise further capital through a placement or rights issue – an offer to existing holders to buy more shares or units.
  • Exchange Traded Funds (ETFs) are a combination of the above and are open-ended funds that are traded on a stock exchange. The fund size can grow as investors apply (to buy) more units or fall as investors redeem (sell) existing units. The difference between an ETF and an unlisted managed fund, is that ETF transactions are conducted on a stock exchange using a stockbroker (on-line or full service).

Style

  • Active management: Unlisted managed funds, LICs and LITs are examples of active management, which means that fund managers seek to analyse, select and monitor the performance of their choice of underlying investments; buying, selling or holding individual selections based on their view of future returns. For example, a selection of listed shares with a view to having these ‘outperform’ a larger benchmark such as the S&P/ASX 200 index. Instead of buying all 200 shares, the manager selects the ones which are believed will give a better result over time.        
  • Passive management: While there are some ETFs that are active, the majority are passive and track an index, such as the S&P/ASX200 locally or the S&P500, tracking the top 500 companies in the US. Passive management, such as that provided by an ETF, will generally deliver close to the performance of the index it tracks – growth and income. ETFs can also provide access to asset classes that may be difficult or costly to hold in a physical form such as gold, oil or currencies. These ETFs track the price of the underlying investment, rising or falling as the gold or oil price moves or as the currency relative to the Australian dollar (AUD) changes.

Access

  • Many SMSFs use the ASX as a way to access shares. However, the exchange also provides access to a growing range of managed investments, such as LICs, LITs and ETFs enabling trustees to use a manager’s expertise to run the underlying investments. In consideration of this the SMSF will pay for the manager’s skills.

  • Investment adviser: Where trustees do not feel comfortable in making investment product choices themselves, they may choose to use a qualified investment adviser to help with the appropriate product selection, under the asset allocation provided in the investment strategy. The adviser most likely will charge a fee for this advice and this cost needs to be considered as a part of the overall cost of the portfolio alongside and underlying costs paid to any managers providing the products.

Portfolio administration

Keeping an eye on a portfolio, in terms of its performance and how it is reflecting the investment strategy is important and there are a number of ways of achieving this depending on the size and nature of the fund.

If the fund has a few investments, a straight forward spreadsheet may suffice, however, if there are a number of investments spread across a number of member accounts, then a Portfolio Administration Service (PAS) may be a help. A PAS is extremely helpful where electronic access is available to investments such as bank accounts and exchange traded and listed products, as close to real-time access to a portfolio may be available.

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