Nick Bruining: Think you know how to run a self-managed superannuation fund? You don’t, and here’s why

Self-managed superannuation fund investors may be relying on luck rather than proven investment strategies to build their retirement nest eggs.

Your Money has been investigating the portfolio pitfalls of those running their own super funds, with suggestions on how to optimise the risk and return trade-offs, by following the strategies of experts who run public offer super funds..

University of Western Australia’s accounting and finance head Professor Lee Smales said SMSFs now represented the second-biggest sector of the $3.5 trillion superannuation sector, with more than one million members.

According to the Australian Taxation Office, more than half of the SMSF money is invested in listed shares, deposits and managed funds, with 10 per cent in non-residential property and 6 per cent in residential real estate.

“While some SMSF trustees have substantial financial experience, many do not have any background in the area,” Professor Smales said.

He suggested the first thing SMSF investors did was establish their overall tolerance for risk. Factors influencing this would include their own personal financial circumstances, timelines and “your ability to sleep at night” when investing in volatile markets.

This then defines the allocation of total investable funds between low risk and risky assets. Risky assets include shares and property while low risk might include government and large company corporate bonds. Only cash deposits are classed as risk-free.

“Fundamental to investing is the efficient market hypothesis which states that an asset price at any point in time fully reflects all the available information,” Professor Smales said.

“This then shows that in the long term, it is impossible to consistently beat the market.”

Professor Smales said following famed investor Warren Buffett’s approach was a good starting point. His methods are what professional investors do regularly.

Professional investors will use a top-down or bottom-up approach, or a combination of the two to decide when to buy, sell or hold an asset.

“A top-down approach starts by looking at macroeconomic trends, such as interest rates and demographics to identify which sectors would benefit most from those trends,” Professor Smales said..

He uses Australia’s ageing population as an example, suggesting health and care-related shares might show reasonable long-term growth.

“A bottom-up approach will focus on selecting stocks based on fundamentals such as revenue, cash flow and competitive advantage,” he said.

Investors can then use valuation indicators to compare assets.

In shares, for example, investors should understand key measures like price-to-earnings and price-to-book ratios along with return-on-equity measures. These might reveal over or underpriced shares.

Professor Smales said concentration risk was a big factor in SMSFs where a large proportion of the invested money was in too few assets. Risk management through diversification is used by professional fund managers every day.

A concept known as the “efficient frontier” shows that proper diversification provides a better overall return for a lower overall level of risk.

To reach the best efficient frontier in shares, for example, an investor would need to hold shares in a range of sectors, rather than concentrating holdings in just one or two sectors such as finance or resources.

Equally, indicators don’t reflect the future prospects of an asset and these are reflected in less tangible aspects such as business opportunities that might affect an asset’s growth prospects.

One shortcut to building a professional portfolio of risky assets is to use managed funds.

US-based Morningstar research provides quantitative and qualitative research on Australian and international funds. Its director of personal finance Mark Lamonica said that SMSF trustees were a big part of their business.

“Investors can access quantitative and qualitative information on funds and shares, with funds ranked from gold star or highly recommended through to negative,” Mr Lamonica said.

A negative rating would indicate a recommendation to sell.

Quantitative data effectively scores a fund manager’s past performance and is often freely available.

Qualitative data is far more intensive and highly valued because it looks deep into factors that might influence future performance. That often includes face-to-face interviews with fund manager personnel.

Many financial advisers subscribe to Morningstar as a basis for their own recommendations.

Morningstar does not accept any payments from fund managers, a critical point of difference to other research houses.

Nick Bruining is an independent financial adviser and a member of the Certified Independent Financial Advisers Association