Finding the right asset allocation for your SMSF

Investment Committee, Switzer Dividend Growth Fund
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Your asset allocation is the core driver of performance through your lifecycle. In future articles, I will go through the core stocks and bonds that should make up your SMSF, but before we start building and dissecting the underlying securities in a portfolio, we need to take a step back and review your asset allocation.

It is no surprise that the appropriate asset allocation will differ for most SMSFs depending on your return expectations, risk tolerance (can you sleep at night?), time horizon and the stage of your lifecycle. This week I will go through a standard diversified balanced fund typical of a ‘moderate’ Australian investor profile and then back-test the performance of this portfolio for the past 20 years. Finally, we will review the outlook and expected returns going forward.

Building blocks of asset allocation

Your asset allocation over time will be the core driver of your total investment returns. Most investors should be diversified across all asset classes, and within each asset class, to help lower the volatility of portfolio returns. The clear goal of course is to have exposure to asset classes that are negatively correlated through a cycle. The 1991-92 Australian recession (our last recession), the Asian financial crisis (1997/98), the technology bubble pop of late 2000, the unforgiving GFC (2008) and the recent European credit crunch are just some clear examples where diversified portfolios significantly lower the volatility of your portfolio.

The starting point, in fact your building block for portfolio construction, is your Strategic Asset Allocation (SAA). Your appropriate weighting to the key asset classes will typically consist of the following: cash, fixed income, equities, A-REITs (listed property securities) and alternatives (that is, private equity, commodity themes, hedge funds). Your SAA weightings will reflect your ‘long-term’ return expectations (you need income to live on in retirement), the level of volatility you can tolerate to be able to sleep at night (negative correlated asset classes’ lower volatility of a total portfolio) and the stage you’re at in your lifecycle.

Clearly, your SAA benchmark weightings will differ if you are 25 years of age versus 50 years. You need more defensive income exposures the closer you get to the pension phase, particularly given the structure of your SMSF in Australia.

There are other elements to asset allocation such as ‘tactical’ sector tilts, which imply going ‘overweight’ or ‘underweight’ the various asset classes versus your bespoke SAA weighting. For example, in late 2011, our standard core moderate investor weighting to cash was a large 7.5% overweight the benchmark. But this is for another time, as we aim to simply explore core outputs of diversification for now.

Let’s look at Figure 1 which shows the SAA weightings for the ‘typical’ moderate Australian investor profile:

Figure 1: Strategic Asset Allocation (SAA) weighting, moderate investor profile

Figure 1 shows the standard weightings across the asset classes: 5% cash (must always be liquid and accessible); 30% bonds (this includes Australian government bonds, Semi-government bonds, high quality corporate bonds and some high-yield securities and global bonds swapped back into Australian dollars); equities (importantly, this includes both domestic equities and global equities); and finally, real estate (which is typically Australian Real Estate Investment Trusts – A-REITs – which are typically listed).

So how did this standard diversified moderate investor profile perform in 2011?

The performance of the diversified portfolio was negative 1.3% last year, which is clearly much more comforting than the All Ords Accumulation Index, which was negative 11.4% over the same time. A 10.1% difference in performance is significant over a 12-month period.

Taking a look over time, Figure 2 shows how this diversified portfolio performed since December 1987 through to December 2011. It shows the simulated historical performance of the portfolio with the time period of the historical financial crises highlighted (except last year’s European Credit Crunch, which will be a new addition soon).

When examining the volatility in more detail since 1987, the annualised return is 7.95% with the best calendar year performance of 26.55% in 1991, and the worst calendar year performance of -20.0% in 2008 (of note equities were down 40% in 2008). It is very clear that the volatility of portfolio returns is much lower with a diversified portfolio. Defensive asset classes (cash and fixed income) did exactly what they were supposed to do in 2011. They returned 5% and 11.4%, respectively. Bonds in particular are a classic negative asset class given their low correlation of returns over time versus equities, but this doesn’t mean you should simply follow last year’s best performer.

Figure 2: Simulated historical stress test of the standard moderate investor

In summary, we have aimed to explore the basic concepts and building blocks of portfolio diversification through a SAA for an average moderate investor profile. It is quite clear that diversification across all the asset classes, and importantly within, are such key concepts that all investors need to be cognisant of for their wealth accumulation. Your asset allocation must reflect your return expectations, the amount of risk you employ (volatility) to meet your objectives and your time frame (which reflects your stage of your lifecycle).

Everyone will effectively need to explore their own bespoke SAA weighting benchmarks, as we all have different requirements and risk appetites. In future articles, I will start to build the appropriate portfolios within the asset classes, starting with equities and exploring a growth equity portfolio versus an income equity portfolio.

George Boubouras is the Head of Investment Strategy & Consulting at UBS Wealth Management.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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