Smart Investor: DIY Super products

Smart Investor – DIY Super report, April 2011

It’s no surprise that, as DIY super has grown into a phenomenal force in Australian superannuation, an investment industry has grown alongside it. It seems that every new product launch is designed with self managed super fund investors at least partly in mind now.

Many new products tend to be based around gearing, which rather divides opinion. Amendments to the Superannuation Industry (Supervision) Act in September 2007 allowed SMSFs to borrow, based on certain restrictions. Since this is the newest significant change, it is also the area of greatest product innovation.

On one hand, the use of gearing in SMSFs is clearly increasing. Investment Trends, the research group, found that the number of such funds using geared investments had more than doubled in less than two years up to April 2010, and predicted it would grow by a further 40% in the next 12 months. 29,000 SMSFs were using geared products in April 2010, up from 18,500 in May 2009 and 13,500 in July 2008.

But, at the same time, that 29,000 total represented only 7% of all SMSFs; the pace of increase reflects the fact that it has only recently become legal to do it at all, hence a rapid percentage increase off a low base. And even that number hits 41,000 over the subsequent year as Investment Trends expects, that’s still very much a minority. “About one in five SMSFs are interested in gearing within the super fund,” says Mark Johnston of Investment Trends. “There’s a level of demand for gearing within the super fund, but at the moment the ones who want to borrow are more likely to do so on property rather than shares.”

When Russell Investments surveyed planners and trustees about the possibilities of gearing in self managed super, a very clear division in outlook became apparent. In short, advisers are more excited about it than trustees. In the Russell survey, two in five advisers said they had provided advice to trustee clients on the new borrowing rules, and a further 15.7% intended to do so in future. But 75.6% of trustees said they had not used the rules to borrow to invest in their self-managed fund and did not intend to do so. The two positions are not incompatible: planners can advise on the opportunities without trustees necessarily taking them up. But it’s clear that, in order, the level of excitement about gearing goes: manufacturer, planner, investor.

Even some planners have their doubts. “One of the best rules surrounding super, in my opinion, was that you generally weren’t allowed to gear,” says Charles Leyland of Leyland Private Asset Management. “Gearing, while wonderful when the market is going well, can diminish your wealth when things are going poorly. And the last thing a retiree wants to see is wealth disappearing.

“I don’t mind gearing: borrowing money to buy an investment property is not a bad thing at all,” he adds. “But in the self managed super fund environment I think it’s just too dangerous. The purpose of super funds is different to other investments: it’s to fund retirement. You don’t want to put it at risk.”

The return of the installment warrant

Still, there are many different ways of getting gearing, and products take different approaches. At the conservative end is the good old installment warrant: buying a share in two stages, but getting full exposure to the dividends and franking credits from the outset.

Installment warrants have been around for years, but have experienced something of a revival in light of the financial crisis. They represent an easy way to make a tentative return to leverage: nothing complex or opaque, nothing too heavily geared, but a way of dipping a toe back in the market.

Westpac, for example, has launched a range of new installment warrants, mainly using the self-funding model, in which the second installment takes the form of a loan which is paid down by dividends from the underlying shares along the way, but upon which interest also accrues.

Cathy Kovacs has been instrumental in launching this range for Westpac. She says there are lots of reasons for the renewed popularity – a return to simple structures after the global financial crisis, an easy method of gearing back into the market – but one of them is because they are eligible for use in self-managed super funds. “The whole opportunity for gearing inside of super is opening up,” she says. “We’re just taking the tried and tested concept of buying a share in two parts, on the lay-by: half now, half later.”

The sort of elaborate structured products that were commonplace before the financial crisis have not yet found their way back into popularity, in superannuation as much as anywhere else. “One rule I’ve followed in 20 years in the share market is not to touch products that are too structured, with too many layers of cost,” says Leyland. “I don’t buy anything too complicated.”

Implemented Portfolios, the financial advisory group, takes a similar view. “My view is that those types of products are facing an uphill battle,” says Jon O’Reilly there. “With the cost and structure of those products they are going to struggle a little bit. Our preference is for transparency so we tend not to go for structured products.” That doesn’t mean there’s no role for gearing in a portfolio. “We absolutely wouldn’t say no, but the key is trustee education: making sure they understand the risks they are taking and the opportunities that may be there. If you have a long enough timeframe, go for it, but if it’s an uninformed decision, that’s where the danger lies.”

Why DIY loves ETFs

Outside of gearing, SMSFs have also had a hand in the growing popularity of one of the simplest products in the market: the exchange-traded fund, or ETF.

“We use them to get a low cost diversified exposure to sectors, countries and regions,” O’Reilly says. ETFs can be increasingly versatile instruments to play particular themes or ideas as the range of available products in Australia grows. “Asset allocation is not just macro,” says O’Reillly. “There are sectors and tilts within that as well.” He says there are “a few gaps in the ETF space, obviously one being around fixed interest, but within equities there is a lot of choice.” Leyland also likes them as “a low cost method of getting exposure. It’s not going to outperform or underperform the market.”

ETF providers themselves have certainly felt a change. “Planners are embracing ETFs, because now they can sit back and look at portfolio construction for the investor and look at getting the correct asset allocation through these instruments rather than through higher cost portfolios, or having to go through a lengthy process of determining the right active manager,” says Drew Corbett at ETF provider BetaShares. “Once you’ve got the sector and asset weights within a portfolio correct, you can devote more time to other needs of clients like estate planning and tax. At a macro level planners have a strong understanding of what sectors they believe are appropriate in a portfolio, and these instruments allow them to reflect that view with a simple investment.”

And the themes of gearing and ETF growth are linked. Corbett has noticed “a little bit of a resurgence in self-funding instalment warrants over ETFs” in light of the rules allowing selected borrowing in self-managed funds. One of the most popular such warrants is over the ASX 200. “One of the reasons for that is the self-funding warrants allow them to gear up, and to enhance the dividend and franking outcome around a portfolio. And in an ETF you get the index as a whole, meaning the volatility is lower than a single stock.” It also remains diversified, by default. “The ETF actively rebalances in line with the index, so it moves towards the better performing companies on a market cap basis over time.”

Elsewhere, enthusiasms include corporate bond product, agricultural schemes (see breakout) and, to a limited extend, alternative investments. But as the asset allocation article elsewhere in this guide demonstrates, SMSF trustees are still very much drawn towards the familiar norms of Australian equities and direct property. SMSFs represent a wish to do our own thing – but having done it, we have a tendency to stick to what we know.

Inside fees

The fee relationship in products is interesting. It’s often said, for example, that the boom in the use of exchange-traded funds has to do with the fact that fewer financial planners use a commission model these days. But a look at SMSF advice shows that this sector is way ahead of the trend away from commissions. According to the Russell survey, only 6.6% of SMSF advisers were charging a fee paid by commission set by the product provider. It seems that SMSF investors are trailblazers in more ways than one: in doing things their own way, they’re also at the forefront of pay-for-advice fee structures rather than products paying a trail.

Breakout: Going agricultural

Elsewhere, some more esoteric investment projects are finding their way into self-managed super funds too. Almond Investors Limited, which has launched a tax-effective almond investment product every year for the last eight years to retail, this year launched a project designed specifically for self-managed funds. Wayne Overall, executive director of Almond Investments, said at the product launch: “We chose to create our 2011 project predominantly for SMSFs because they would generally have the ability to fund ongoing obligations, avoiding the need for individuals to use their own monies or organise debt finance.” In short, the SMSF becomes its own bank to fund the investment.

Projects like this are not for everyone – and plenty of schemes within the tax-effective agricultural sector have been attacked for failing to deliver over the years – but there is some logic in pitching such long-term projects (almond trees have a 30-35 year productive lifespan) to super funds, which have the time horizon to deal with them. “This is a long term investment, but given the longevity of Australians entering retirement, it is not an exceptionally long timeframe,” Overall says.

The fund becomes an almond grower, makes payments over a five year period, receiving tax deductions along the way, and then receives 61% of harvest sale proceeds from years 6-17 (with the individual investor taking the balance) and all the proceeds up to the 30-year mark. Overall describes it as suiting “part of a retirement planning strategy so that [the] investment is cash positive when they retire, thus giving themselves the opportunity to earn annuity income during their retirement years.”