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13 Sep 2019 Regarding Member 233’s comment ‘ATO letter about SMSF diversification and concentration’

Tax Counsel Angie Ananda writes: 

Thanks for writing into TaxVine, Member 233. The Tax Institute is currently raising this issue with the ATO. 

MEMBER 240 writes: 

I strongly support Member 233. His SMSF client with an LRBA received an ATO letter that seemed to the client to imply non-compliance and potential fines because of limited or no investment diversification. I understand the ATO letter requires trustees to give reasons for their decision to concentrate investments. 

Reg 4.09(2) does not require diversification or written reasons. Nor does it empower the ATO to judge an SMSF’s investment choices. I recommend you read it. 

The requirement of Reg 4.09(2) is to consider relevant factors, including risks from inadequate diversification. 

Risks come both from diversification and the lack of diversification. 

Diversification’s risk, in a world of uncertainty, complexity, human frailty and the future’s opacity, including, dare I say, our mutual ignorance, is the risk of loss by poor investment choice. 

Collateralised debt obligations (CDOs) are a great diversification example. Though professionally created and recommended by major banks and brokerages, leading up to and via the GFC, diversification into CDOs cumulatively caused billions of dollars of losses in Australia and worldwide for many professionally operated endowment funds and local government bodies, and to individuals and super funds. They were a main cause of the GFC. 5% or 10% in CDOs will have wiped out an entire year’s earnings for many. 

Diversification is risky. You may not solve that risk by picking a winning investment adviser. What is chance and what is skill? Very difficult to discern. Read Nassim Taleb and others. You may not solve that risk with exchange traded funds (ETFs) either, which may force lower returns solve it (see later). Despite his advocation of ETFs and famous in-the-money bet favouring them, even Warren Buffet does not practise his preaching or not substantially enough. AFI’s and the Future Fund’s ETF investments may be guessed or estimated at proportionally low to nil. 

Our major banks’ diversification by investment in wealth advisory businesses is very much on point. Other instances are their diversifications by investments in overseas banking – BHP’s and Rio’s attempts to diversify into shale oil and aluminium refining, respectively. A highly visible proportion of these diversifications, made by some of the world’s and our country’s reputedly best business people, ended in write downs, fire sales, tears, loss of capital measured in billions and destruction of investor value. Why will diversification work better for an SMSF than it did for them? 

A fundamental business and investment tenet is to operate and invest only in what you know. That might mean only one asset, because you (like most) might have a limited field of knowledge. Further, especially early in its life, an SMSF’s capital will be limited. To make meaningful investments, it must concentrate its funds. This, by the way, can be a major virtue of LRBA’s, though they need great care. It is also why many successful businesses stick to their knitting and businesses that don’t are often not successful. 

The best performed SMSFs among many I’ve reviewed were those that, with funds of $100,000 to $200,000 or so, invested in the mid to late 80s in single investments that the SMSF director(s) knew very well indeed – interestingly, investments most advisers would not then recommend, but which time proved very sound. Pending identifying those investments, those funds mostly held cash, some for quite a few years. Those SMSF trustees were patient for the “fat pitch”. Those SMSFs have a twenty to thirty-year compound earning rate in the range of 15% to 20% per annum, or somewhat higher and, unsurprisingly, have today grown to be very substantial. Also, interestingly, their investments, though no longer single assets, remain very concentrated in what each set of trustees knows well. 

Present government and regulator emphasis on public offer and industry fund performance and arguments that lower performing funds should be forced into amalgamation evidences the official view of underperformance as a major risk. These SMSFs’ operators’ view then and now was that in all the circumstances, diversification’s underperformance risk was by far the biggest risk and required asset concentration. Their long-term comparative track record strongly suggests they were right. 

In short, it does not follow that lack of diversification need be a problem, either legally or operationally. 

Reports suggest the ATO letters, which I have not seen, are unbalanced. Though they may indicate the actual regulatory requirements, they do not state that SMSFs are not required to be diversified, they do not state the ATO does not have power to rule on SMSF investment choice, they do not state that trustees are not required to record reasons and that a strong body of opinion holds that trustees’ and directors’ records, while perhaps recording factors, should not record reasons for decisions. Whether or not intended, unless the letters are rebalanced to state these limits, perceived ATO power will cause many, like Member 233’s client, to read the letters as if an in terrorem regime requiring diversification. People will, wrongly, get the impression that the ATO has power to rule on an SMSF’s investments. Yet, the requirement is to consider, not necessarily to have, diversification and the ATO does not have power to rule on investment choice. Minutes and the strategy are evidence of whether reg 4.09 was complied with. Trustees have no obligation to share their reasons with the regulator, even if, to minimise trouble, doing so may be an attractive option. 

I recommend the ATO amend its letters. Arguably, the ATO should simply ask for a copy of the relevant minutes and investment strategy (which may be a single document) to check if the fund complies with the law, as that is what the law deals with. Regulators do not have the skill set to rule on SMSF investment suitability, and the law does not give the ATO or any regulator a role to stand in judgment on SMSF investments, how trustees balanced risks and benefits or why investments were made – in our SMSF regime, that is self-interest’s role.

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