Before I start my next cycle of sector reviews, I want to take a big step back and review my whole SMSF portfolio with you, as I decide my next steps. Readers from two weeks ago may recall I was selling banks in my margin loan account (outside of super) but not in my SMSF. I now have no banks – or, indeed, any financials, property or telcos – in my margin account because I see no capital gains of note in these sectors – so I don’t want to borrow just to make very small gains on the dividends.

It is timely for me to review my own SMSF portfolio since I haven’t rebalanced it for at least six months, although I monitor valuations and stock prices every business day. But first, let me reinforce my dividend convergence story, so that I can clarify my different positions in my SMSF and margin accounts.

Dividend convergence

I have been arguing my case on Switzer TV for over six months using a chart such as that in Chart 1. As can be seen, telcos came with an expected yield of nearly 8.5%, financials about 7.5% with property and utilities in the high 6%’s – all as measured at the beginning of 2012. With the chase for dividends, stock prices in these sectors have shot up at a much faster pace than dividends. As a result, yields have fallen and, interestingly, the range of yields across these sectors has been compressed into a very tight range – much tighter than any other time on record.

Chart 1: Dividend convergence

Since April/May 2013, these yields have moved very closely together. If yields fall too low, these sectors are no longer ‘yield plays’ and so future capital gains become less likely. APRA has now told the banks to not increase dividends and this message further reinforces the imaginary ‘floor’ I have put on these yields, at about 5.0% to 5.2%.

Since my SMSF is in pension mode, I do not pay tax on my SMSF dividends. I have a modest inflation-protected reversionary pension flowing from my academic days, my bank dividends give me a sufficient top-up to my pension for a ‘comfortable’ lifestyle – but I would prefer something more comfortable. Therefore, I am interested in some capital gains in my SMSF, so that I have all bases covered – but I think I can easily wait 10–20 years for these capital gains to come to fruition! One can (and should?) have a long-term view at 64 years of age, as I do.

I have tabulated the index weights for each sector of the ASX 200, along with my own SMSF portfolio in (the column headed Ron) Table 1. I have almost exactly index weight on financials at 39%. However, I am almost double index weight in energy and materials. I have steadfastly stood by my version of the China story for 18 months, as some analysts and investors deserted these sectors. I only hold 14 stocks at the moment.

Table 1: Sector statistics

I have also tabulated my forecasts of capital gains, yield and volatility for each sector in Table 1. These figures clearly show part of the reason why I have ‘tilted’ my portfolio the way I have. But to get the full story, one needs to also take correlations into account. I publish two sets of ‘optimised weights’ in my Quarterly Report on woodhall.com.au. Neither is designed for implementation but they do give readers some insight into how all of these forecasts of returns, volatilities and correlations interact. The aggressive weights are particularly aggressive allowing major deviations from the index weights, while the less aggressive weights still allow for very big positions.

The aggressive and less aggressive weights for financials are both well below index weight. But I have elected not to own property and telco stocks so, in a sense, I have reallocated those two sectors’ weights to my financials. My portfolio is punching above its weight in energy and materials. One reason for this tilt in my portfolio is that I think the brokers’ forecasts of earnings and dividends – which form the basis of my gains’ forecasts – are seemingly slow to react to the plethora of great numbers coming out of China.

Changes ahead

The item that catches more interest from me is my underweight position in utilities. Given the strong forecasts of gains and yield for utilities, I now plan to increase my exposure to this sector – to be well overweight! I am looking at possibly buying more AGL (ASX code AGK) and returning to owning Spark Infrastructure (SKI) after a long absence. However, my mispricing model tells me the market is overpriced and I will await a small correction. Perhaps Monday was the start of it. The big banks dominated the fall – it is consistent with my view but day-to-day calls are beyond what I try to do. I am in no rush to rebalance.

I am also considering increasing my weight in energy – for obvious reasons given Table 1. I am looking at Oil Search (OSH ) but again I want a pull-back first. My problem is, I do not have any significant cash holding in my SMSF that could fund these possible purchases. Therefore I must sell before I buy. It seems logical to sell a little from materials – but they seem to be on a charge. Therefore, I must watch carefully and sell a little of my materials if they get sufficiently highly priced before the other stocks get cheap. If I miss the rebalance – it will be because I am making too much out of materials and that can’t be bad.

Expected returns

At the bottom of Table 1 you can see the impact of the various strategies on expected portfolio capital gains and yields – if you use my forecasts. The portfolio return is calculated by multiplying the appropriate weights column (or your own!) by the column of forecasts. The index comes in at a modest capital gains’ forecast of 6.8% and an expected yield of 4.5%. I expect only a slightly lower dividend of 4.1% with my allocation but a much bigger gain of 9.5%. If inflation runs at 3% per annum, the inflation-adjusted index return is 3.8% while mine is 6.5% – and that is not far off double the index forecast! Of course my forecasts could be very wrong and a very different set of results would then follow. But this is how I have done my modelling for 10 years or so.

Important: 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. Consider the appropriateness of the information in regards to your circumstances.

Also in the Switzer Super Report:

• Charlie Aitken: East Coast recovery rolls on for JB Hi-Fi, Bendigo and CSR
• Penny Pryor: Buy, Sell, Hold – what the brokers say
• Penny Pryor: Short n’ Sweet – IPO watch
• Tony Negline: Don’t let inflation be a distraction
• Paul Rickard: NAB’s new hybrid security
• Tony Negline: Set your kids up financially… for life – Part 1
• Question of the week: What’s in a short?