The role of the Investment Strategy

Important advice…

Having a sound investment strategy is not only a sensible thing to do, it is a legal obligation of SMSF trustees.

The law doesn’t set out exactly what the investment strategy needs to look like, or what it must contain, but it does provide some guidance to the effect that the investment strategy for the SMSF needs to consider diversification, which means investing in a range of assets and asset classes, among other requirements.

This means that all SMSF ­trustees should regard the risk-versus-­return profile of different assets, and the needs and circumstances of the members of the SMSF.

It is also important to consider the liquidity of the SMSF assets (which means how easily they can be converted to cash) and the SMSF’s ability to pay benefits, for example when members retire and other expenses that may arise.

As part of the formulation and regular review of an investment strategy, SMSF trustees also need to consider whether it is appropriate for insurance, such as life insurance, to be held within the SMSF for each of the members.

With no prescriptive formula, there are many approaches to the investment strategy trustees could take. It’s important to think about a target you are trying to achieve with the SMSF investment — for example, CPI plus x per cent return (you insert the “x”) over a five- year period.

This takes into account the fact that investments and markets can and do fluctuate.

Many investment strategies also nominate a targeted asset ­allocation by asset class, as well as risk tolerances.

As an example, a target of 40 per cent invested in Australian shares, and a tolerance of plus or minus 20 per cent performance. This enables the trustee to set a target range for what they would like to achieve in terms of performance, without adjusting the investments unless it falls ­outside this range. In this example, if the value of Australian shares across the SMSF’s portfolio stayed within 20-60 per cent there would be no change required unless the trustee wanted to.

Where some SMSFs get it wrong is to set a target, but allow the tolerance to be too broad (between 0 and 100 per cent). This usually isn’t a sound investment strategy as there is no real goal the strategy can be measured against.

A sound investment strategy is not usually a set-and-forget ­approach — it should be reviewed regularly. As a trustee, you can leave the strategy unchanged, or change from one year to the next as required. The big question is how often should a fund’s investment strategy change?

Provided your investment strategy is in line with the legal requirements such as diversification and liquidity, then your documented strategy doesn’t have to change very often. Importantly though, this doesn’t mean that you can’t change the underlying investments more frequently.

Considering that an investment strategy is usually set at an asset-class level (for example, Australian shares), there is plenty of opportunity to make changes within that asset class. But remember that there are a number of considerations to take into account when making these changes.

It’s always great to know that you can exit at the peak of a cycle and realise the gains from an investment. However, often it’s difficult to know when that peak has come. If an asset has performed ­really well, it doesn’t necessarily mean it’s time to sell it, although that’s always an option to consider. Remember that selling an asset at what you believe is its peak means you have to consider not only the usual transaction costs of changing investments, but also you are realising a potential capital-gains tax. Don’t think of capital gains as being an issue, as it means you have made money on the investment, but after allowing for the tax you will have less value to hold or reinvest.

Another item often overlooked is when trustees choose to buy property through an SMSF. Because of the level of investment required, this will often be a large percentage of the fund’s value, so can affect an existing strategy with a low allocation to property. Remember, you can change the investment strategy at any time, to account for a change in allocation — but it’s important to ensure you have considered and documented why this remains appropriate for the fund and its members, taking into account the reduced diversification and liquidity.