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Is Your SMSF Investment Strategy Meeting Diversification Requirements

Just a couple of years back (August 2019), the Australian Taxation Office (ATO) sent a dedicated letter on the matter to some 17,700 trustees and their respective auditors of self-managed super funds (SMSF) with exactly this title: Is your SMSF investment strategy meeting diversification requirements.

The letter was sent when the records of ATO showed that an overwhelming share (90 percent or more) of the super funds are allocated into a single asset or a single asset class. The beneficiaries of the letter were requested to review their investment strategies in view of their diversification potential. The trustees were requested to be ready for an auditor revision of their investment strategy, … or else. The “else” in this case is a fine of AUD 4,200.

It is exactly here that we need to mention that the ATO does not have the authority to suggest which assets need to be sold or bought. Neither can it in any way compel an SMSF to sell any of its non-diversified assets. However, what ATO wants is that each SMSF clearly understands the risks involved in the over-concentration of his investments. The trustee is also required to explain the reason for this over-concentration and ways to remedy this circumstance. Hence the fine is really a way to protect the trustees, than anything else.

Legal 

The legal superannuation requirements (Superannuation Industry Supervision Regulation 1994) stipulate that each self-managed super fund (SMSF) must have an investment strategy. According to the Australian Taxation Office, this investment strategy is necessary so that your fund has a written plan on how to make, how to hold on and how to realise the super funds needed, as per your (and the rest of the fund members, if such exist) initial financial targets.

Part of (some investors like Warren Buffett argue that it is “most of”) the ability of your SMSF to make, hold and realise the necessary funds is linked to the diversification of investments. This complicated and often used financial term is a sophisticated way of saying, “Do not put all your eggs in one basket.” This, in fact, is sound financial advice.

The necessity of each investment strategy to monitoring its investment diversification is defined in Part 4.09 of the Superannuation Industry Supervision Regulation 1994 – The Operating Standard for the Investment Strategy. In its second paragraph, the need for the trustee to formulate, monitor and enact the Investment Strategy which clearly takes into account the composition of the investments and their diversification. The trustee is also required to understand the risks of having over-investments into a single asset or asset group – the risk of inadequate diversification.

The Reasoning

The whole idea behind these legal requirements is that ATO is weary that trustees of SMSF may not be aware of “holding all the eggs in one basket,” as mentioned, although obviously, ATO uses a different language. So, ATO makes it a mandatory part of the Investment Strategy of the SMSF and is inclined even to collect penalties in the event of over-concentration of the investments within a single SMSF.

The Danger

OK, we know that ATO is trying to forfeit a danger to the SMSF and its trustees. But what is it? Why can’t an SMSF invest all its funds into a single asset or asset group? Adding to the wisdom of the eggs and the basket story, we should note that if the investor chooses to invest all in a single asset (or asset group), she is highly exposing herself to risks of losing return on investment, suffering from volatility (change of price of the investment) and unstable liquidity (lack of the ability to withdraw funds from the investment).

The worst case scenario for a concentration of investments is a leveraged investment. This is the case when a limited recourse borrowing is used to acquire the asset/s in question. The issue here is that a fluctuation of the price of the asset/s will not only cancel the anticipated returns and compromise liquidity but that it is possible to trigger the total sale of the asset (at unfavorable prices) and negate the whole SMSF altogether.

What ATO is trying to achieve is that investors in an SMSF are aware of the risk of lack of diversification.

The Solution

When the funds are invested in a variety of assets all of the above risks are strongly decreased. The logic is that should one asset (or an asset group) be compromised due to myriad reasons – crisis, fire, climate change, market, etc., the financial implications on the overall portfolio will not be devastating.

In order to accomplish the diversification requirement, investors should consider allocating percentage-based investments of their funds into a variety of different assets. Such allocations of investments will vary over time; however, the overall fund management will not be in danger of fluctuations from investments into a single asset or asset class.

The diversification of the investment strategy of the SMSF is not set in stone. As markets will vary over time, when new members join the fund or when one of the members starts to receive a pension, the strategy should be reviewed and updated accordingly. Reviews of the investment strategy need not wait for such an important event. ATO advises for annual reviews, coinciding with the annual meetings of the trustees. The minutes of these meetings and strategy reviews can then be used as a document for the SMSF auditors – proving the understanding of any concentration risks which have arisen and the steps taken to mitigate any possible negative consequences.

Should the above investment diversification requirements prove challenging, it is reasonable to seek the support of qualified support. Such may be rendered by qualified accountants, business accounting firms, or best from a specialised in the business superannuation accountants or self-managed super fund accountants or even better local Melbourne accountants, https://kpartners.com.au/. The latter will help with the best local information to facilitate your SMSF diversification management.

Red Note: 30 September 2022

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