Understanding asset classes
Cash is considered to be a capital stable secure asset class – capital invested will be returned.
The liquidity of cash assets varies with some ‘at call’ – where funds invested can be accessed in need, or ‘fixed’ for a term, where an investment is accessible at the maturity of the term.
There are a range of ways for a SMSF to hold cash across a range of products, such as:
- Bank accounts or Cash Management Accounts (CMAs)
Often central to managing a SMSF these accounts provide transaction capabilities to receive income and contributions, make payments, such as pensions and expenses and provide for good record keeping by way of a monthly statement. These accounts provide functionality in exchange for a lower interest rate with funds at call.
- High Interest Savings Account (HISA)
A HISA provides a higher rate of interest at call and is linked to another bank account providing a way to move cash in and out electronically – online and ‘park’ it for a period, earning a higher rate of interest before moving it back to the bank account when needed.
- Term Deposits (TDs)
Term deposits provide a way to receive a known fixed rate of interest for a specified term – providing certainty. Typically, terms can run from a few months up to 5 years with interest paid at varying intervals – such as monthly, 6 monthly or annually. Providers may offer the choice of having interest reinvested in the term deposit at maturity or paid into a separate account.
SMSFs could choose to open a number of TDs, for differing amounts each with varying terms and perhaps with varying interest payment periods to accommodate expected cash flow needs as interest is paid.
The setting of interest rates on cash assets can vary:
- Call accounts rates are often set against the Reserve Bank of Australia (RBA) cash rate, sometimes at a margin above the RBA cash rate, that is RBA rate + x%. As the RBA rate moves up or down, the margin remains the same, but the overall rate will change.
- TD interest rates are set by the institution on a needs basis usually to assist in funding lending. Should there be a need to ‘break’ or access the TD before its maturity date, there may be a cost by way of a reduced rate being paid.
Financial institutions in Australia are only permitted to accept deposits if they are an Authorised Deposit-taking Institution (ADI). ADIs are regulated by the Australian Prudential Regulation Authority (APRA) and the Australian Government guarantees deposits up to $250,000 in ADIs such as banks, building societies and credit unions.
Balanced against these security benefits is the risk of receiving returns that will be below that of inflation or being locked into a TD investment at a lower than current market rate.
Bonds are a type of fixed term investment, similar to term deposits in that capital invested is scheduled to be returned at a known future maturity date.
When a SMSF invests in a bond it is effectively providing a loan to another party – typically government or corporations such as large companies. The bond is issued for a set amount – ‘face value’, for example $1,000 and the issuer agrees to pay interest on specified dates and at specified rates with repayment of the face value of the bond at maturity.
There is a very large bond market that enables bonds to be traded with other investors seeking to buy or sell. This market provides liquidity for bonds in much the same way as does the stock market for equities.
Direct access to the bond market can be difficult for SMSFs, as while the face value of a bonds is relatively small, to participate in the market, the size of bond transactions can amount to several hundred thousand dollars.
However, SMSFs are able to access bonds in smaller transaction sizes using ‘packaged’ solutions where specialist bond managers will access the bond market, acquire a large parcel of bonds and split into smaller investment parcel sizes – say, $100 face value. In this way SMSFs can access the liquidity of the bond market in smaller amounts.
Depending on the credit rating of the issuer, the rate of return offered on the bond will vary accordingly. A well rated issuer can offer a lower rate of return based on a higher likelihood that the bond holder will receive their money back at maturity.
The Australian Government issues a range of bonds – Australian Government Bonds (AGBs), which are issued to raise money to carry on the business of running the country. Given the high credit rating of the Australian Government, the return on AGBs is relatively low. For this reason, they may be seen by SMSFs as a secure investment, albeit at a low return.
Australian Companies raise capital to run their business, with corporate bonds forming part of the company’s capital structure alongside shareholder equity – it is another way of raising capital.
Corporate bonds can provide a further way for SMSFs to invest in a company, but potentially at lower risk than being a shareholder, as bonds rank above equity in the capital structure, meaning that in the event of the company being wound up, bond holders would be paid before shareholders.
The global bond market is very large, deep and liquid. It too is characterised by government issuance as well as from corporates. Notable differences include the size of some of the companies that issue bonds and the breadth and nature of the business sectors they represent.
Investing in global bond markets may be good for diversification, however a SMSF may choose to use a specialist bond manager to guide investments decisions and to invest through a managed fund that specialise in these markets.
Bond investments should not be made on yield alone. In considering a bond investment, SMSFs should research the underlying credit ratings of the issuer. An issuer with a low credit rating may need to offer a high coupon to attract investors.
Returns can also vary according to the broader market interest rates; if rates are higher than the bond rate, the bond price could fall.
When a SMSF makes an equity investment it is effectively becoming a part owner in a company by taking an equity stake in the fortunes of that company. The proportion the SMSF holds in the company is its ‘share’, hence the expression of it being a ‘shareholder’.
Shares in companies do not have maturity dates as the company continues to operate as management changes over time and even as the nature of the underlying business of the company changes. That said, companies can be merged taken over or go out of business.
Direct and easy access to the Australian equity market has proved popular with SMSFs. The ability to buy and sell shares on-market provides liquidity for investors to manage a share portfolio. The price at which shares trade is determined by what sellers are will to sell for and buyers will to pay.
The Australian share market is a similar size as the Australian economy, however, accounts for a small proportion of the global equity market.
While there are over 2,000 companies listed on the ASX, it is characterised by a few large companies that participate in a few sectors such as, resources and financial services. The top 200 companies account for around 80% of the total value listed with many SMSFs holding a high proportion of investments in this grouping.
This domestic bias is not unusual as it reflects the greater understanding SMSFs have of local companies with easy access to real time news and information domestically.
Australian companies pay dividends from profits after tax and the payout ratio for Australian companies is high by global standards.
Having so much of the global equity market outside Australia and with many more sectors beyond resources and financial services available, there may be a case for SMSFs to consider diversifying away from the domestic bias of only holding Australian shares.
However, with many global share markets trading when it’s night in Australia, it may be difficult to make direct share investments and keep an eye on real time news and information. For this reason, it may be useful to consider using an investment manager who specialise in international shares. This could be achieved by investing with though a managed fund, where the manager, who may be based in the international market, has the expertise to make investment decisions for investors.
Global companies tend to have lower payout ratios than do Australian companies, choosing to reinvest earnings back into the company to achieve growth over the medium to long term
Share prices can be volatile and move significantly over short time frames. As a result, investors may not be able sell at an acceptable price or even sell at all if there are few or no buyers in the market.
With international shares, there are also currency considerations, which provide another dynamic as currency fluctuation can affect outcomes in terms of both growth and income.
Property has long been a favoured investment asset class for Australians generally as well as within a SMSF structure. However, the nature of the underlying investment varies between the two investor types, with SMSFs holding a higher proportion of non-residential property than residential and retail investors tending to invest in residential property outside a SMSF. This does not say that SMSFs do not or cannot hold residential property as an investment class.
Investments in property can be subject to ‘property cycles’, which are driven by expectations around property values. If there is a predominate view that property values will rise; prices tend to follow. As the term suggests, cycles do move from a low, through a peak and descend, so the reverse applies when the view on property values switches; prices can fall.
Property cycles may vary in terms of the nature of the underlying property type and the drivers and duration of the cycle may be different for each property type. A strong economy can drive the demand to commercial property, such as offices and warehouses, while a growing population can drive demand for residential.
To achieve diversification across the property component of an investment portfolio, the SMSF should hold a range of property types to take advantage of different cycles.
If the preference is to hold the properties directly, it may be difficult to achieve a broad enough spread of property types, as the cost associated with buying one, let alone a number of properties could be prohibitive.
Listed Property – Real Estate Investment Trusts (REITs or A-REITs in Australia)
There are a number of sectors available, including:
- Office – holding one or more office buildings usually in capital cities or major regional centres. Income is derived from business paying rents to accommodate their workforce.
- Retail – shopping centres or shopping malls where income is derived from rents paid by tenants such as shop and business owners.
- Industrial – usually warehouses that are used by businesses to store and/or transport goods.
- Diversified – a combination of the above, or
- Specialised – where the investment relates to a specialised area such as retirement facilities or bulk storage.
The trust structure by used REITs provides a different way of paying income. Unlike equity or share investments, tax is not paid at the entity (trust) level and income after costs is passed through to the investor (SMSF) with any tax considerations worked out at tax time.
SMSFs can hold property directly, however, the capital required to buy a number may see the SMSF focus on small commercial properties, such as the business premises used by small business – office, factory or warehouse. The businesses that use the facilities can be operated by members of the SMSF. The alternative may be to own one or more residential investment properties.
Running a direct property portfolio can introduce an added level of administration that requires a more ‘hand-on’ approach, with trustees collecting rents, paying bills or finding new tenants when needed.
Not having sufficient funds to invest directly in a range of different property asset class types could see a SMSF:
- invest in one only, opening it up to the cyclical movements of that type alone
- invest a disproportionally high amount into one or a few assets due to the cost associated with buying property.
As the name would suggest, alternative investments are different from mainstream asset classes such as cash, equities and property.
When a SMSF invests in alternatives, it may be seeking to achieve a range of outcomes such as:
- receiving uncorrelated returns, which are returns from asset classes that do not match or correlate to the return profile of mainstream asset classes. In other words, when mainstream asset classes are underperforming, Alternatives may compensate
- investing at an early stage in emerging asset classes to gain a benefit of appreciating asset prices
- investing in collectables
- Uncorrelated assets – In terms of uncorrelated returns, precious metals such as gold may represent a ‘flight to safety’ solution when financial markets experience ‘shocks’, such economic disruptions leading to downturns in global markets.
In a similar way, if there were to be a disruption in the supply of crude oil, this may flow through to businesses that rely on oil to operate and see their values fall, while the value of oil grows.
By holding appropriate amounts of uncorrelated assets, SMSFs may protect part of the overall portfolio from these types of events. However, exposure to alternative should be considered as part of the overall investment strategy.
- Emerging asset classes – An example of opportunity could be seen in emerging technologies and the products that those technologies make possible. Many technologies used today in everyday life started out from an emerging asset class – take mobile communications and data for example.
As a way of considering the relationship between a product and its technology take crypto currencies and the technology they run on – Block chain as an example. Which will be the better investment; investing in the currencies or what could become a more widely used technology, which will be more or less volatile, which will turn into the sustainable asset class of the future?
A further example would be peer-to-peer lending (P2P), which operates outside the traditional banking system to advance loans. What will be the impact on traditional financial services providers, such as banks? So too, with after pay, what does this mean for bank credit cards?
- Collectables – This in itself is not a cohesive asset class as there are so many variations on this theme – artwork, jewellery, antiques, coins, banknotes & stamps and even motor vehicles. The one theme they do have in common is that SMSFs hold these types of assets usually because they are well understood by one or more trustees of the fund. As such, it could be argued that this knowledge will guide good investment decisions.
This is probably true; however, when considering collectables, it is important to refer to the sole purpose test ‘your SMSF needs to be maintained for the sole purpose of providing benefits to members upon retirement or to beneficiaries if a member dies’ and as a result trustees can have no personal use of these assets.
Effectively this means that in the case of a vintage motor vehicle, a trustee cannot drive it or of jewellery, it cannot be worn by a trustee. There are also strict requirements that these items be stored and insured in the name of the SMSF and there are also costs associated with independent valuations.
Alternative assets provide SMSFs with an opportunity to add to a portfolio’s diversification, however by their nature, they are not income assets and are considered to be growth in nature.
Additionally, there may be difficulties if the need arises to sell these assets as there is generally no broad market providing valuations and a buyer may only be willing to pay a price below that of the valuation held by the SMSF.