How to boost your SMSF by diversifying

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Self-managed super funds (SMSFs) tend to pick Australia's top 10 to 20 stocks when investing in the sharemarket, including the big four banks, Telstra, Wesfarmers, Woolworths, BHP Billiton, Rio Tinto and Woodside - companies that are well researched and pay good dividends.

But this may have a downside.

Some experts say this approach may leave SMSFs too concentrated in just two sectors - banking and mining, or "homes and holes" - and relying too much on the banking and mortgage sector in Australia and the strength of China.

woolworths

Anton Tagliaferro, investment director of Investors Mutual, says most of the top 20 are good-quality stocks but offer too little diversification.

"Around 70% of the top 20 are basically in the financial and resources sector. Being heavyweight in those two sectors has paid off for many investors because both those areas have performed well over the past few years," he says.

"The question is, as we go forward, with China now slowing more dramatically than previously thought and new capital requirements in the banking sector because of the Murray inquiry, perhaps profit earnings won't be as strong. That's the issue with the lack of diversity."

Tagliaferro says markets are unpredictable and can turn quickly, which is why it is important to reduce risk as much as possible. "All you can do is hold a diversified spread of quality assets and ride through the cycle."

The top 20 stocks make up about two-thirds of the S&P/ASX 300 Index. So "buying the index" - that is, investing in an index fund - won't solve the problem. This is where specialist funds may have a role.

To give SMSFs greater diversification, Investors Mutual has launched a listed investment company, QV Equities, which invests in quality companies, such as Amcor, Ansell, Orica and Sonic Health, that have strong global growth prospects.

Philip La Greca, head of SMSF technical services at AMP, says many SMSFs are in pension phase, which is why they gravitate to the top stocks.

"One advantage of those stocks is they pay good dividend yields. They also tend to pay franked dividends, which in pension phase on a zero tax rate means you get a full tax refund.

"From a cash-flow viewpoint that's one of the big attractions."

But he says SMSFs are also pragmatic enough to use a fund manager when it makes sense to do so.

"It's hard to pick stocks when you go below the top 20 or top 50 because they are not as well researched. So where SMSFs do get advice, they tend to balance out those risks. Clearly, if you've got exposure to the top 20 or top 10 companies and you buy an ex-20 Australian equities fund - a fund that's buying everything except the top 20 - there's your exposure to the other parts of the index."

Hedge your bets

Morningstar's model Income Portfolio of 15 stocks is a mix of SMSF favourites and other companies outside the ASX's top 20 stocks.

It has no resources stocks.

Peter Warnes, head of equities research, says companies are selected on the basis of their sustainable competitive advantage and are hard to compete against.

"That allows them to earn excess returns over the weighted cost of capital. Excess returns over cost of capital means excess returns to shareholders."

He describes competitive advantage as an "economic moat". The big four banks, for example, have a very wide moat and are all present in the portfolio. Companies must also have stable dividends and low share price volatility.

Warnes says the Income Portfolio has outperformed the S&P/ASX 200 Accumulation Index "by a country mile".

"Since inception in 2001 the market's up 8.2% per annum and we're up 12.3%pa. Over a five-year period the market is up 6.8%pa and we're up 13.5%pa."

It holds AGL, AMP, APA Group, ANZ, BWP Trust, Charter Hall Retail, Commonwealth Bank, National Australia Bank, Scentre, Sonic Health, Spark New Zealand, Telstra, Wesfarmers, Westpac and Woolworths.

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