Investment strategy and diversification

Date of article: 30 August 2019
Last updated: 30 August 2019

The Australian Taxation Office recently announced that it intend to contact trustees where the SMSF may be holding 90% or more of its fund in one asset or a single asset class.

The ATO has raised the concern that some trustees have not given due consideration to investment diversification. The ATO stated that this can put the SMSF’s assets at risk.

The regulations do not require that the investment portfolio of the SMSF be diversified. Where it is not diversified, the trustees need to document the risks from inadequate diversification.

Where the SMSF lack diversification, the ATO takes the view that the investment strategy should "...clearly document the reason behind the investment decisions."

The ATO also state that trustees must be able to provide "...evidence of how they consider their investment strategy meets the following requirements:

  • the diversification of fund investments
  • the risks of inadequate diversification within the context of their SMSF investment portfolio (for example, the risks associated with the fund's investments in a diversified portfolio of shares is likely to be lower than that of another asset class, such as cryptocurrency) [emphasis added]
  • the making, holding, realising, and the likely return from their fund investments relating to their retirement objectives and expected cash flow requirements
  • the liquidity of their investments, allowing the fund to meet costs and pay benefits as members retire
  • whether insurance cover should be held for one or more members."

The ATO also reminds SMSF trustees that the lack of diversification or concentration risk, can expose the SMSF and its members to unnecessary risk if a significant investment fails.

The regulations

Regulation 4.09 of the Superannuation Industry (Supervision) Regulations 1994 applies to SMSF in relation to investment strategy. Specifically:

4.09(2) The trustee of the entity must formulate, review regularly and give effect to an investment strategy that has regard to the whole of the circumstances of the entity including, but not limited to, the following:

(a) the risk involved in making, holding and realising, and the likely return from, the entity's investments, having regard to its objectives and expected cash flow requirements;

(b) the composition of the entity's investments as a whole, including the extent to which they are diverse or involve exposure of the entity to risks from inadequate diversification;

(c) the liquidity of the entity's investments, having regard to its expected cash flow requirements;

(d) the ability of the entity to discharge its existing and prospective liabilities;

(e) whether the trustees of the fund should hold a contract of insurance that provides insurance cover for one or more members of the fund.

Meeting the diversification requirements

"Diversification helps you ride out the ups and downs of financial markets by spreading your money across different asset classes. It will leave you less exposed to a single economic event, so if one business or sector you've invested in isn't performing well, you won't lose all your money. Diversification reduces overall investment risk and reduces volatility of returns on your investment portfolio as a whole." - ASIC's MoneySmart website.

The regulations do not require that the investment portfolio of the SMSF be diversified. Where the investment strategy is not to diversify, the investment strategy must document the risks from inadequate diversification.

There may be situation where diversification may not be desirable or appropriate, for example, where members of the SMSF are in advance stage of retirement phase and investments are concentrated in basic cash products (bank/ term deposits). In this case, their aversion to risk should be documented in the investment strategy.

The investment strategy information above is of a general nature and should not be interpreted as financial advice.

Do you need help with your situation or if you wish to discuss the above, please contact us. Our contact details.

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