As another financial year ends, the underperformance of Australian equities continues. The last six months has seen quite severe ASX200 underperformance of global markets. I think this will continue in FY18.

One key reason is we can find genuinely better earnings growth outside of Australia, particularly in the Eurozone and Hong Kong. We can also find faster GDP growth and less regulatory risk outside of Australia. We can find all this for lower forward P/Es than are broadly available in Australia.

I am not anti-Australia, far from it, my AIM Global High Conviction Fund picks the best of Australian equities and the best of global equities. This combination of great domestic and global stocks is driving our returns well above what the ASX200 has delivered over the two years we have been running the fund. We are also well ahead of the MSCI World Equity Index.

While I understand what drives Australia SMSF home bias, I am of the view, as I have repeatedly written in these notes, that you have to lose some of that home bias to generate the best returns available.

According to available data, SMSFs have very minimal exposure to global equities. That will continue to be a mistake in asset allocation terms.

Yes, collecting big fully franked dividends inside a SMSF structure is attractive from an income perspective, but you simply aren’t generating any capital growth. If you want capital growth, you need earnings growth and most large fully franked domestic dividend payers have very little earnings growth. In fact, many have negative earnings risks as we enter FY18. This again reaffirms my view of Australia for income, rest of world for growth.

My advice to anyone who asks me is, SMSF’s should NOT be reinvesting the fully franked dividends they receive from Australian in Australian equities. They should be diversifying into global growth equities. I believe this is the right strategy that will see SMSFs increase exposure to global growth themes while still holding their beloved Australian dividend streams.

If you continue to reinvest dividends in Australian high fully franked dividend stocks, you are basically INCREASING your exposure to the highest Australian property prices ever at the lowest interest rates ever. That isn’t a good idea.

The major ASX200 dividend payers are very leveraged to all things housing: whether they lend over houses or sell consumer goods to households. We are strongly of the view that house prices have peaked and consumer spending is weakening due to a household cash flow squeeze.

Of all the economies that we look at globally, Australia concerns us the most in FY18. We are coming into a housing and consumer downturn with households and government heavily indebted.

Household and government balance sheets are stretched, coming into a slowdown: that is NOT a good place to start.

I am also increasingly concerned about regulatory risk in Australia driven by populist politics, clear examples of which can been seen in the Federal Bank tax and South Australian Bank tax. We think private healthcare will be targeted next.

Foreign investors HATE regulatory risk: it’s a green light to short or sell a market that represents only 2% of the world. Foreign investors DON’T have to be invested in Australia and that’s what politicians need to understand. Foreign investors also can’t value franking credits.

Similarly, they also need to understand that taxing banks will only lead to higher mortgage costs for all Australians. Out of cycle rate rises had already started to cool the residential investment property market and there will be more of them, further squeezing household cash flows as banks exercise their oligopoly pricing power. There is zero any government can do to stop them setting their own rates of interest for loans.

Unintended consequences of ill thought through populist policy is Australia’s biggest headwind. It has and will continue to affect the returns you can generate in Australian equities. That is why my fund continues to only invest in Australian stocks we think are broadly immune (hopefully) to regulatory risk at the Federal and State level. We’re also increasing exposure in ASX listed global earners as we feel there are growing downside risks for the Australian Dollar, which if proved right will erode Australian’s global purchasing power.

The ASX200 is also the most concentrated developed world market.

Australia’s share market is concentrated in banks and miners, which make up 62% of the index, three times more than the global index exposure.

Meanwhile, the top 10 stocks in the Australian index make up 47% of the index, compared with 11% globally.

Even after considering the potential tax advantages from investing at home, the concentrated nature of Australia’s share market makes it a more risky proposition.

Allocating to international stocks would reduce portfolio volatility, or risk, without having to give up returns.

If all your eggs are in Australian equities, you are basically invested in the most concentrated equity market in the world. You are also missing out on any true technology exposure, which is a mistake.

However, the biggest question we need to ask ourselves is whether SMSF demand for fully franked domestic dividend stocks is actually holding the Australian economy back?

Large cap Australian companies have broadly increased dividend payout ratios to feed the SMSF army what they want. That comes at the expense of capex spending or reinvestment in growth.

In my view, these increased dividend payout ratios are NOT finding their way back into the domestic economy. They simply get reinvested by SMSFs into their super fund. The ageing population who control the vast bulk of SMSF wealth cheer, but the economy is actually a net loser due to the lack of multiplier effect of that money being spent.

Similarly, large domestic companies cutting capex to sustain high dividend payout ratios is reducing cash movement through the economy. Everyone is a loser when capex is cut. That is one reason Australian GDP growth remains soft: large companies favouring dividends over investment in the future.

Most large Australian company boards find themselves between a rock and a very hard place. Now they have attracted the SMSF army to their share registers, with the bait of high fully-franked dividend payout ratios, they can’t cut them. Look what happened to BHP when they abandoned the “progressive dividend policy”. This scares boards who are very aware that the SMSF army could abandon them if they don’t get what they expect. Imagine what would happen to Telstra if they went to a 50% payout ratio and invested in growth?

I’ve had conversations about this with some board members of major Australian companies, who can’t see a balanced way forward that doesn’t involve share price pain if they lower payout ratios to invest in growth.

I remind these company directors that at the end of the day, their job is to sensibly allocate capital to consistently grow their business. At times through the cycle different variables will drive demand (or not) for certain attributes, but at the end of the day all that really matters is the company is advancing, not retreating.

As Warren Buffet says, in the short term the market is a voting machine, in the long term it’s a weighing machine.

And interestingly, Mr Buffet’s Berkshire Hathaway has NEVER paid a dividend. He believes in compounding capital and he is right. I wonder if Australia would be better served by more companies that took Berkshire Hathaway’s approach to compounding capital via sensible investment (return on capital above cost of capital), rather than blindly giving the SMSF army what they want today?

Berkshire Hathaway long-term price chart

This won’t change tomorrow, but in my view the Australian tax system as it currently stands reduces the growth potential of the Australian economy. The structural change to self managed super funds is also playing a role.

If you want your big fully franked dividends and negative gearing, then the trade-off is slower economic growth. You can’t debate that.

Obviously none of this is going to change in FY18, these are just my opinions above. However, no change ensures that my long-held view of Australia for income, rest of world for growth firmly stands.

I believe the ASX200 will continue to underperform the world in capital growth terms in FY18, but clearly offer a better dividend yield (plus franking credits), than the rest of the global equity world.

I also remain of the view you all need to lose some degree of your home bias to generate better total returns in the year ahead.

Happy new financial year.

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.