To have a meaningful impact there are four main objectives for the SMSF portfolio to reach. After the slew of new ETFs and other products on the ASX, investors are now spoilt for choice. But the challenge facing investors is knowing how to put these products to use in an SMSF. Here’s a guide of what to look for and some of the companies we’re using in portfolios right now.
For reference, ETFs are Exchange Traded Funds, and Listed Investment Companies (LICs) are commonly used in SMSFs too. These are the two main groups we’ll look at in detail below.
For SMSF portfolios there are four key areas most should meet. When met, the portfolio is harmonious and the members are happy. If not met, the portfolio is more hassle than it’s worth and retirement isn’t what we all thought it should be.
The four key areas most SMSF portfolios should meet are:
- General market exposure (beta)
- Income (yield)
- Capital Growth
- Absolute Return
In theory we’d aim for each investment in the portfolio to have a bit of everything. But in reality, that’s not possible. Where it appears possible, the returns of those investments suffer and we just end up on the roller coaster of the index.
The magical question then becomes how much to allocate to each group. In practise it’s not as straight forward because in reality we need to address value.
For example, looking at the LICs with the strongest capital growth on the ASX, the majority are running at 5-25% over their actual value (Net Tangible Assets, or ‘NTA’).
Buying a 20% overvalued company means that we’re paying $1.20 for $1 which is not a good investment in anyone’s book. Although there are some LICs on the ASX that hold these leading shares and are trading at a discount.
A Dynamic Portfolio
The realistic response to these real-time idiosyncrasies is that the portfolio needs to be dynamic.
Too dynamic and the costs ratchet up and becomes nonsensical. There is a happy medium somewhere in-between, but the amount of movement is dynamic to respond to what’s happening in the market.
There will be times the portfolio doesn’t move much. Other times it will need to update itself in response to the domestic or world economy evolving.
Core and Satellite
The most common response to this dynamic question is a ‘Core and Satellite’ approach.
The majority of funds (cash) are invested in a core portfolio. The core portfolio is somewhat linked to the index and mostly passive. The remainder of the funds (cash) are invested in Satellite investments that will change with market movements.
The core and satellite approach works for most of the time. Although we don’t need to look any further than the ASX since May 2015 to see that being linked to the ASX indices has been less than fantastic. In hindsight we can see that being more closely linked to International shares for 2013-2015 was the best area for a portfolio, then from 2015 being aligned with the smaller cap shares would have been ideal.
As the saying goes ‘hindsight investing is with 20-20 vision’. The logical response to these constant movements in the market is a dynamic core with satellites.
Dynamic Core with Satellites
Following the same principle as core and satellite, but enabling the core to adjust too – within reason.
Up until about two years ago this portfolio approach would have required buying and selling lots of individual shares and constantly shuffling the portfolio around.
However, over the last few years there have been many new listings on the ASX, many of which have been looked at in detail at ShareCafe.
The listings of interest are ETFs and pseudo ETFs called Listed Investment Companies (LICs). LICs follow a similar principle to ETFs by holding a basket of shares but are normally actively managed shares (along with a few key technical and legal differences). Household LICs names are Wilson, Argo and Milton.
ETFs vs LICs = Active vs Passive Management
The Active manager’s vs passive manager’s debate is something I look at constantly. Mostly because I find it very interesting, but also because it’s topical right now.
Topical because the ASX has churned sideways which brings manager fees into question and the search of where to find real performance.
To summarise this debate; the studies from Standard &Poors (S&P), that are echoed time and time again are that large-cap active managers rarely out-perform the index, and when they do, it’s not for long.
S&P’s research also shows that sometimes mid, small and micro-cap active managers do outperform the index. Although this is not so often in large, well-researched markets like the US, UK or EU markets. However, with remarkable consistency, the mid, small and micro active managers (LICs) in Australia outperform the index.
This research tells us that we’re more likely to be rolling the dice with an active manager in the large caps (and individual investors are too when we try to bet on the individual large caps). Although we’re far better off with an active manager in the smaller companies on the ASX.
Looking at S&P’s research above means that it is difficult to justify an LIC in the AU large-caps.
We often look at Vanguard High Yield (VHY) to satisfy this requirement. (Note, there are a few near-identical alternatives offered by competitors).
The reason we look to VHY is that it focuses on income as well. There are numerous research papers and studies that show how important income is to a long term portfolio. VHY is a cost effective way to get access to the market (Beta) and extract a strong income (plus reasonable franking credits)
While there are active managers in this space. Justify their fees based on out-performance (or lack thereof) can be a little difficult.
However, there is one great anomaly in the LIC market-linked/Beta space through the Future Generation Fund (FGX). FGX pays no fees and annually donates to charity on investor’s behalf – a great initial that is a different story all in itself.
Small Cap Exposure
S&P’s research numbers show this is where the value really started to be added from the LIC managers.
The obvious place to look is WAM Capital (WAM), but they have been running at huge premiums for almost two years now. It’s difficult to justify buying these shares at such high prices, paying $2.30 for $2.00 worth of shares. Mirrabooka (MIR) is in the same boat.
Next we can look at the more recent LICs to come to market. There are many trading at discounts to their worth (NTA) which seems odd considering the premiums held by WAM and MIR. However most of these recent listings have two main differences.
1) The LIC has a small shareholder base to spread the ASX listing fees across. Most fund managers aim for $75m as a point where economies of scale kick in for them. While this is a target, the point is the lower the market cap of the LIC, the more fixed ASX fees you’ll be paying per share. This smaller size can encourage the LIC to trade at a discount.
2) There are outstanding options as an overhang from when the IPO listed on the ASX (IPO’d). Often the LICs will give participants in the IPO free options to buy more shares at the IPO price in one or two years’ time.
The options help grow the fund quickly to resolve the issue mentioned in (1) above, but it is an injection of cash.
If the LIC is fully invested now (no cash in the bank account) this could be great, as the fund can invest in more opportunities.
Although if the fund is sitting on a lump of cash, then the existence of the options questions just how good the performance of the LIC will be if they have even more cash sitting in the bank account.
Logic implies that the LIC’s performance will drop as it is spread thinly across less active investments (not cash).
On the other hand, once the options have expired and the new cash raised from the options has been invested there’s an argument that the LIC could play a quick catch-up. That would see the LIC move quickly from a discount to NTA, to NTA or even a premium to NTA. Some astute investors use this as a trading strategy in itself.
There are a few LICs that sit in this options/discount space. Their performance is great and we often add these companies to portfolios seeking capital growth and small/mid/micro-cap exposure. They are:
Income and Franking
Income is important and we have learnt that a low growth environment over the last few years, along with numerous academic studies.
Often SMSFs with larger portfolios will be content with making money and address drawing on income as or when it is needed. This approach often creates incomes as a positive side-effect of addressing the other investment objectives (Beta, growth, capital gains, absolute returns).
Franking credits can also be a welcomes side effect.
Property makes up a large chunk of the ASX relative to other developed exchanges.
The nature of the underlying assets also implies a steadier growth pattern and less erratic swings in asset valuations. Just think of how much your house price changes on a daily or monthly basis – very little. On that basis, this asset class is a prime candidate for extra income strategies achieved from options strategies.
The most efficient way to get this exposure is through the ASX-listed fund that has been managed by a highly experienced portfolio manager Hugh Dive. The options strategies make the yield on property assets almost double (8% vs 5%) and apply a quality filter so the portfolio of property shares held are only 6% over actual value compared to the property index of 18%.
While we can zoom in and focus on what most Australian advisers know best – domestic shares – that leaves a hole in the portfolio international exposure.
Many investors were inspired to buy some shares with international exposure when this part of the market was running in 2013-2015. The early investors were reward with some capital growth from ASX listed shares while the AUD fell.
It is possible to repeat that process; in effect investors are replicating an exposure they want through in inefficient method. Although times have changed, with the recent listing on the ASX over the last few years, so most investors can do a better job now than a few years ago.
In short buying direct shares with international exposure is more expensive and holds a higher risk than what is available today. Here are three recent IPOs are examples:
- The IPO of DMKT. This is an AMP fund that addresses the inefficient problem we just mentioned (along with other competitor’s products in the same space)
- ANZ ETFs US high-income ETF (ZYUS) and Euro STOXX 50 ETF (ESTX) earlier in the year.
DMKT provides an interesting middle group of ETF/LIC approaches, semi-active funds. Not pure index, not pure active management. This approach has also been provided with some Betashares products on the ASX for a few years now.
After speaking with some well-regarded Australian research houses, they have been sceptical of new ETFs that have listed shortly after the index has been created, seemingly just for the ETF’s existence. These analysts cautiously cite debacles of new-index ETFs in Korea and Japan, although this chapter is yet to be written in Australia with the highly regulated Australian market.
That leaves the active and passive debate for international. This can be addressed with active or passive an investor wants to be. The question is whether to take one fowl swoop to this whole portion of the portfolio (DMKT or the like). Or use the tools and leavers investors now have available with all the new ETFs and LICs to make the portfolio more specifically accountable over time.
a) A passive portfolio could have DMKT
A DMKT-type ETF would mean that the portfolio only needed rebalancing in the context of international vs domestic exposure (less leavers to keep the portfolio on point).
This example breaks the international exposure into three separate ETFs getting US, EU and emerging markets separately.
The upside is that investors can look through and see which is performing and or isn’t.
That detail can then help investors move their leavers to add or subtract into certain areas. This becomes and active stance and requires occasional re-weighting of the portfolio
Example portfolios could invest in:
- Large Cap (core): VHY and FGX (provides income too)
- Small/mid-caps: CIE CTN (provides income and capital growth too)
- Micro caps/Capital growth: 8EC and MA1
- AREIT/Property: Hugh Dive’s Property portfolio (provides income too)
- International: ZYUS, ESTX WXHG
- Active Satellites: dependent upon market conditions, situation trades (Buy-backs etc.)
Disclaimer: This is a hypothetical portfolio and is not a recommendation to trade or buy these investments. Please consult your investment specialist for personal advice.