SMSF Investment StrategiesSharing Simple Strategies for Self Managed Super Funds
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Investment Strategy Part 3: Passive vs Active Investment Methods
This is Part 3 of a four part series of posts on Preparing the Investment Strategy for your SMSF (the complete series can also be found on the Articles page). In my previous post, I talked about using Asset Allocation as an investment method. This is a passive investment method and we found it inadequate for two reasons:
1) It does not really minimize risk. During the Global Financial Crisis, all asset classes except Cash and Fixed interests fell in value. We tried diversifying into alternative asset classes like Gold and Silver and they fell even more than stocks. One of the risks with investing in a new asset class is your level (or lack) of skill in selecting and managing the right investments within that asset class. If you are a seasoned stock investor, you will know successful stock investing is more than just buying a basket of stocks. You need to have some understanding of the company fundamentals and valuation and you may use technical analysis to pick a good time to buy/sell the stock. Likewise a seasoned property investor would know which suburbs to buy into, how to negotiate a good deal, etc. Most of these skills are developed over time and you are most likely to make the most mistakes with your first few investments in that asset class. Another danger in investing in a new asset class is that you may not understand all the risks associated with it. We learned our lesson when we invested in Managed Forestry Schemes. We were attracted by the tax benefits and we thought it was a simple business model (how hard can it be to grow trees?) and there seemed to be a ready market for timber products. We also liked the idea of owning a “green” investment which was in some way reducing the carbon emissions and making our planet a better place. We were shocked when Timbercorp and Great Southern went into voluntary administration and our investments are now worth next to nothing.
As I read the articles in my ASX Investor Update for July 2009, the hot topic was clearly “How to increase my returns for 2009″. I think everyone agrees that it will be very challenging to get good returns from the share market in the next few years. Some of the expert contributors were suggesting trying out new asset classes like Corporate Bonds and Hybrids as a way to increase yield. I don’t know much about these products but I would suggest investing very small amounts into any new asset classes as I am sure there are many risks that you may not be aware of or understand yet.
2) It may not be able to get you the return you want. If you are looking for an 8% return per annum and the values of all the non-cash asset classes are stagnant or falling, then your only choice is cash or fixed interest. If the returns of these are only 3-4%, then how can you get the returns you want? That was the question we asked ourselves in August 2008 when the RBA started to cut interest rates and we decided to try another investment method which is to actively manage our investments to increase returns.
Active investing to increase returns
We all have our favourite asset classes that we are comfortable with. Mine is definitely shares but Kingsley’s favourite is property. One of our friends is a very successful property investor but is completely hopeless with shares. He used to invest in shares by following his broker’s advice and gave up after he got burnt by HIH. The more you invest in one asset class, the better you get at managing it. When I first started trading options in the US market, I used have sleepless nights worrying about my positions. I tried out various trading strategies and finally found some that worked for me. Now putting on those trades has become routine and even when I have to take a loss, it does not worry me as I already know my risk and reward beforehand. My position has been been sized so the maximum risk is a manageable amount and I know the probability of my trade working out in my favour.
Based on the data from the Australian Tax Office (ATO), direct shares is one of the favourite asset class for SMSFs. About 24% (AUD81.6 billion out of the AUD327.8 billion) of SMSF funds are currently invested in listed shares and equities (source: Asset Allocation Table – March 2009) and it is the second most popular asset class after cash, debt securities and term deposits. If you are a share investor, you may be better off learning some new strategies to actively manage your share portfolio to improve your returns. Some of the expert contributors on the ASX Investor Update have suggested buying small cap instead of blue chips, buying stock with good dividend yields and using stop losses. My humble recommendation to stock investors is to learn options and use them protect your stock portfolio and to generate additional income.
Options have been around for a long time but for some reason many people are still fearful of them and think they are high risk. Some accountants even tell their clients they cannot use options in their SMSF, probably because they do not understand options themselves. There is no restriction on using options as a form of investment, as long as the SMSF does not borrow (see Page 5 of this document Income Tax Treatment of Exchange Traded Options, written by a partner from Ernst and Young which is on the ASX website).
In summary, there are alternatives to changing asset classes to manage risk and improve returns. Our investment strategy for 2009 definitely includes using options to:
- protect stock positions when market falls
- buy stocks at a discount
- generate additional income in a flat market
- make money in a falling market
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