Completing the performance picture

The investment performance of SMSFs has never been accurately or adequately measured. Research and analysis released this year, however, may have changed this situation for good, Tia Thomas reports.

Conjecture has always existed as to how SMSFs compare with Australian Prudential Regulation Authority (APRA)-regulated funds on both a cost and performance basis. Research commissioned by the SMSF Association and SuperConcepts and conducted by Rice Warner in 2020, titled “Cost of Operating SMSFs 2020”, covered off the argument from a cost perspective. It found SMSFs with a balance of $200,000 or more are as cost effective as their public offer counterparts and further, SMSFs with an asset balance of $500,000 or greater are in fact the most cost-effective superannuation option period.

But what about the performance of SMSFs? How does it compare with APRA funds? For so long this has been very difficult to determine given the differences in portfolio construction and the lack of information providing the level of granular detail required to make a valid comparison. This state of affairs has allowed preconceived ideas about the lacklustre returns SMSFs have generated to linger, much to the joy of sector critics.

However, research released in February this year by the University of Adelaide in conjunction with the SMSF Association, titled “Understanding self-managed super fund performance”, provided a more scientific and accurate measurement of how SMSF investment performance compares to APRA-regulated funds.

Data for the study was sourced from BGL Corporate Solutions and Class between 1 July 2016 and 30 June 2019 and analysed information from more than 318,000 funds in order to more accurately identify the asset threshold needed for SMSFs to deliver comparable returns with larger public offer funds.

The motivation to conduct the research was instigated by consistent messages from the Australian Securities and Investments Commission (ASIC) and other government agencies stating SMSFs required a minimum member balance of $500,000 before they should be considered a viable retirement savings option for Australians.

According to ASIC, SMSFs with balances less than $500,000 had lower returns after expenses and tax in comparison to APRA-regulated funds.

However, the research from the University of Adelaide’s International Centre for Financial Services (ICFS) challenged this belief and found only a minimum $200,000 balance was needed to gain competitive investment returns with APRA-regulated funds.

SMSF Association deputy chief executive and director of policy and education Peter Burgess says the research has challenged popular opinions.

“As the fund balance increases, the performance of the fund improves and then once you hit $200,000 that alignment starts to level off. It is essentially a straight line from thereafter,” Burgess says.

“What that is saying is ‘yes, the performance of the fund improves as you approach $200,000, but beyond that the fund size has no relevance to the performance of the fund’.

“This really challenges what APRA has said and the information made available to licensees about how much people should have as a minimum to start an SMSF.

“For example, ASIC guidance 206 – which is guidance issued to licensees around self-managed super funds – notes that people should have around $500,000 before considering setting up an SMSF. This research really challenges that.”

These findings closely align with the conclusions of the Rice Warner study that, as referred to earlier, also identified an asset balance of $200,000 as a prudent threshold to justify SMSF establishment on a cost basis.

“The research shows that if you have a balance of $200,000, it is viable to start an SMSF and when you have particularly over a million dollars, then it can be a lot cheaper than a APRA-regulated fund,” actuary and Rice Warner co-founder Michael Rice says.

However, Rice acknowledges the importance of having performance measurement data to complete this finding.

“Now, price is not the only criteria. Of course there is no point being cheaper than APRA-regulated funds if you have a terrible performance,” he notes.

With reference to the University of Adelaide study, he notes that while its conclusion regarding the $200,000 threshold may seem like an anomaly, it can be achieved, but the trustee still requires a sound understanding of investment strategies or support from a financial adviser to enhance performance.

He illustrates his point using the recent strengths and weaknesses of some popular asset classes among SMSF trustees.

“A lot of people buy property or shares and that can really improve returns when things go right, but you can also wipe your money out if they go wrong. It is important to note we have been living in a period where equities and property have done very well,” he explains.

“If you have a portfolio largely invested in growth assets, then your returns will have been sound. But anyone who invested in government bonds over the last 15 years will not have experienced good returns because interest rates have been very low. Worse still, most ATO statistics indicate that quite a lot of SMSF money is in cash, further hampering returns.”

Looking at specific elements of return generation and the comparison between SMSFs and public offer funds, the University of Adelaide found median APRA funds outperformed SMSFs in two of the three years analysed, but this result was reversed once smaller SMSFs with balances below $200,000 and less than 80 per cent of cash or term deposits were excluded.

To this end, the SMSF Association noted self-managed funds with significant cash holdings were associated with performance impairment during the financial years analysed.

This was particularly noticeable in 2017 when SMSFs were found to have experienced a median return of 6.9 per cent, while APRA funds enjoyed a median performance of 7.8 per cent. However, when cash-heavy funds were excluded from the analysis, SMSFs achieved a median return of 8.0 per cent.

“What the research found is that SMSFs with very large exposures to cash – funds which had 80 per cent or more of their investments allocated to cash – underperformed compared to larger funds. I do not think that is surprising when you look at interest rates, which are very low,” Burgess notes.

According to Burgess, this finding emphasises one of the report’s key messages regarding the importance of SMSF portfolio diversification as a means of improving fund performance.

University of Adelaide lead researcher and ICFS business school deputy director George Mihaylov reveals there is a subgroup of SMSFs that hold excessive cash balances, which are further negatively impacted by the low interest rate environment.

Despite this, he says cash may become a more attractive asset class given the inflationary environment that economies globally are now experiencing.

SuperConcepts SMSF technical and strategic solutions executive manager Philip La Greca points out performance measurement and the role cash allocations play may not be as straightforward as it appears.

“How many of those funds with large cash holdings are SMSFs wholly in pension phase? That is something that was not determined in the research and that is because trying to extract that information is not easy,” La Greca explains.

“SMSFs entirely in pension phase by their nature are going to be more conservative in their investments and require more cash. Of course, if you are more conservative, your returns tend to also be a bit lower.

“The old argument is over a 10-year cycle, you have three negative years. The impact of having those three negative years to a pension fund upfront, compared with at the end of 10 years, can reduce the drawdown someone receives from that fund by 30 per cent.”

Still, SMSFs that have pursued diverse investment options across various asset classes, including listed Australian equities, listed international equities, listed trusts and unlisted trusts, have been shown to produce better performance outcomes.

The University of Adelaide found the least diversified SMSFs recorded the lowest performance outcomes, but enjoyed a strong performance benefit across all financial year periods by simply including one additional asset class.

“We found that there is a strong performance diversification relationship,” Mihaylov confirms.

“Systematically, there are underperforming funds that are holding assets in two or three classes. But that relationship becomes slightly weaker after three asset classes are included.”

From a financial adviser’s perspective, La Greca notes the research highlights the benefits of diversification and the subsequent need to encourage SMSF clients to move away from significant allocations to cash or conservative assets that have a history of underperformance.

Further, he says the study has supported the belief that funds need to prioritise their performance rates more.

“We have not really had a proper comparison between APRA funds and SMSFs before. I think this will actually start to impact the funds themselves to begin to look at their performance and to benchmark it,” he says.

The difficulty in fund performance comparison to date has stemmed from incompatible methodologies used by different sources.

Historically the method by which the performance of SMSFs has been evaluated stems from the ATO’s ability to produce a return on assets (ROA) measure based on information collected from annual returns.

By contrast, APRA gathers data from the financial statements of funds in order to determine a rate of return (ROR) gross of contributions tax and insurance flows.

The research highlights the significant differences that have made accurately comparing SMSFs and APRA-regulated funds difficult, due to inconsistent measurement methodologies.

To illustrate the inaccuracy of the traditional performance measurements, the University of Adelaide study obtained a median ROA for SMSFs during the same period as the ATO statistics to compare the primary performance ratio differences.

This exercise shows the median SMSF ROA is underestimated by more than 1.9 per cent in the three-year period. As such the study recognises how the gap between ROA and ROR has become increasingly severe.

Moreover, these traditional techniques have to date been used by government agencies to assess the appropriateness of SMSFs.

“The Productivity Commission a few years ago did a review of the efficiency of the superannuation sector based on ATO calculations of returns,” Burgess recalls.

“In the research they were able to replicate the ROR performance calculation. We think it is a much more accurate calculation than what has previously been available to the Productivity Commission when they have been asked to look in the past.”

Given the magnitude of how SMSF performance levels have been underestimated, the conclusion is that future methodology should involve a more critical analysis with an inclusion of behavioural impacts in summary statistics.

To this end, Mihaylov notes the sector continues to advocate for updated summary statistics.

“Unfortunately, there are some structural limitations in the whole process, which means that the comparisons can’t be completely fixed. Return on assets will never be fully compatible with rates of return,” he says.

Burgess concurs, but reveals the SMSF Association has approached ASIC with copies of the University of Adelaide research paper with a view to initiate a change in evaluation and guidance practices.

“We have written to ASIC and provided copies of the research. In light of the findings in this research, we have asked them to review their guidance materials that are made available to licensees who provide advice to clients about selfmanaged super funds,” he says.

“ASIC is looking at the research and is considering the issues that have been raised in this letter back in February.”

While the research papers have both challenged traditional perceptions of SMSFs, Rice notes this may not be enough to alter assessment procedures from Treasury and other government bodies.

“The real fear for Treasury and government is that some of these SMSFs are not paying enough tax because they have money squirreled away in these funds. It has led to APRA suggesting capping people’s super balances at $5 million,” he says.

“It is sort of a little bit baffling but that is because it’s politics not policy which is how our system works.”