3 top assets for SMSF protection

Christine St Anne | 17 Apr 2014

Christine St Anne is Morningstar's online editor.

Warren Buffett once said: "Rule number one is never lose money. Rule number two is to never forget rule number one."

Buffett's words would have resonated with retirees during the global financial crisis. Compared with market gains, emotions run a lot higher when investors are hit with capital losses.

In fact, investors have had to delay their retirement by 6.3 years to recover a 25 per cent capital loss, according to Ibbotson Associates Australia managing director Chris Galloway.

Understanding capital preservation is about understanding the risk, Galloway said at the recent Morningstar SMSF Strategy Day.

"Risk is the permanent loss of capital in real terms over the investor's time horizon," he says.

We all know that in Australia, local shares remain a cornerstone of investors' portfolios, including self-managed superannuation funds (SMSFs).

Given that recession is the dominant driver of falls in corporate earnings, this makes portfolios vulnerable to market and economic risks.

"SMSF investor portfolios are dominated by assets that rely on economic growth. Therefore, it is important to look for investments that are not so reliant on good economic outcomes to diversify total portfolio risk and thereby reduce total portfolio losses when equities and bonds perform poorly," Galloway says.

For Galloway, the best diversifiers are investments with "idiosyncratic risks," which are priced to generate higher net returns than cash.

In essence, these assets should have: a low correlation to equities and bonds; low sensitivity to economic growth; an attractive reward for risk based on valuations and fees; higher returns than cash; and a low risk of large losses.

Galloway identified three assets that possess these characteristics:

1) Global listed infrastructure

This very heterogeneous asset class includes: social infrastructure (schools and hospitals); regulated assets; user demand assets (road, rail and airports); and competitive assets (certain power generation and energy trading assets).

Galloway says it is important to invest in assets that do not have too many equity-like characteristics, such as airports.

"While airports are viewed as monopolistic they are vulnerable to the economy. Airport travel is not essential as people can always curtail their plans for a holiday in Hawaii to a weekend in Wagga," he says.

Investors should therefore target infrastructure assets with true monopolistic characteristics, such as transmission and distribution assets.

"These regulated assets give investors a regulated return on assets, including inflation-adjusted returns. People use power, even in an economic downturn. Power will be the last thing people will turn off in a recession," Galloway says.

The biggest risk to these assets is, of course, government regulation. Galloway says it is important that investors diversify this government risk by choosing fund managers who invest across the different infrastructure assets.

2) Insurance-linked securities

Insurance-linked securities are also known as catastrophe bonds. These securities provide insurance against events like earthquakes and hurricanes.

Investors pay their capital into these assets, which then pay a coupon that is a few points above the cash rate.

"What we are trying to do here is get a steady earnings stream with little capital loss," Galloway says.

Therefore, it is best to get diversification. It is very rare that these events would occur at the same time, but what is important is that these natural disasters are not linked to the economy.

Galloway notes that in 2008 - at the height of the global financial crisis - these assets fell 3.5 per cent. While these assets fell 6.5 per cent in 2011 after the Japanese earthquake, portfolios still "managed to recover nicely".

3) Hedge funds

In their simplest forms, hedge fund managers don't benchmark their portfolios to market indexes. Rather, they benchmark their returns against cash and aim to generate a return that is in excess of the cash rate. They do this by using different strategies.

These approaches include long/short strategies, which essentially aim to exploit market mispricing.

The biggest risk to hedge funds is not the economy but a manager's skill.

Galloway says hedge funds have had a chequered history. Given that these managers use sophisticated trades, investors must therefore choose managers with the right skills.

"The fundamental risk in hedge funds is not economic recession but fund selection. Therefore, investors should choose fund managers who invest in a wide opportunity set that includes currency, bond and equity markets."