My SMSF – the importance of a Plan B

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Key points

  • The yield-seeking trend will end when interest rates start going up (but this won’t happen for 12 to 18 months).
  • The Aussie dollar should fall during this year, which means an exposure to US shares could be wise.
  • Consider offloading other holdings that aren’t doing well.

What’s going on?

Many SMSF investors with direct equity portfolios might soon be in for a shock. About half of our ASX 200 index is accounted for by the so-called high-yield sectors (financials, property, telcos and utilities). It so happens that an index of just these four sectors (with market capitalisation weights) out of the eleven sectors of the ASX 200 outperformed the broader index by an average 7.6% over the last four years – and the worst outperformance in that period was as high as 6.6%! If dividends – but not franking credits – were reinvested, the average outperformance rises to 9.8% with the lowest outperformance being 8.3%.

It follows that anyone focused on picking a yield portfolio from these sectors in recent years would have found it hard not to outperform the ASX 200! A dart board, twenty darts and a list of the top 100 stocks from those sectors was unlikely not to have produced a superior performance in each of these last four years.

But far from my trying to rain on your parade (including mine and anyone else’s), there is an important lesson to be learnt before it is too late. In the previous eight years (2003 – 2010) – the longest period for which data are available – there was only one year when the high-yield index outperformed the ASX 200 on price (1.1% in 2006). There were only two years when total returns outperformed the ASX 200 (2.3% in 2006 and 0.1% in 2009). The average underperformance of high yield was 4.6% on price and 3.3% on total returns.

Do you think SMSF trustees are ready for the future?

My main point is simple. Most SMSF’ers didn’t start managing their own investments until recently and so they could easily be misled by their own possibly superb track records.

So what does the future hold? The simple answer is that no one knows with any real degree of certainty. The best answer is “create a strategy that balances the expected risks and returns”.

I am now very happy with my current SMSF portfolio but I know I need a ‘Plan B’ for when I sense a new direction is starting to emerge.

The yield-seeking trend of recent years will almost certainly end – and possibly within the next 12-18 months. The question is when. Four successive years of yield seeking came into being because yields on bonds and interest rates became so low that investors were forced to look elsewhere for income.

Australia is still one of the few AAA-rated countries around and our companies pay almost twice the dividends of their US counterparts. On top of that, Australian residents often receive franking credits. As long as this low interest regime exists, it is reasonable to continue to invest in the yield play. When it stops, share prices on high-yield stocks might tumble – and quickly – as investors flee ‘risky equities’ for the safety of bonds and cash at home or overseas. So do I need a hard hat and a high-viz vest? If so, when?

So what are you doing about it?

My current SMSF portfolio is 3% cash, 18% international (an ETF from iShares called IVV), 28% “Hybrid yield-conviction portfolio” (that I regularly write about in this column), and 51% ‘Other’ (a portfolio of ASX-listed blue chips). Although I am extremely happy with my portfolio (at the moment), I need a Plan B scenario analysis more now than in recent past.

1). If the Aussie dollar does depreciate significantly, as I anticipate, at some point I will consider the Aussie dollar may have bottomed or over-sold. As a rough approximation, I can add my expected depreciation in the Aussie dollar to my expected total return for the S&P 500, which currently stands at about 11.5% for 2015, to get a return on the iShares Core S&P 500 ETF (IVV) of about 21.5% for a 10% depreciation in the Aussie dollar and 31.5% for a 20% depreciation.

2). If I then expect the Aussie dollar to rise, possibly after having overshot some fair value, I don’t want to stay in the unhedged ETF as the appreciation will then work against me. I will trade IVV for another iShares ETF, called IHVV, which is the hedged version of IVV. I will make the transition smooth, in the sense that I will sell off my IVV in about three parcels over time and place the proceeds straight into IHVV to keep my sum of IVV and IHVV about the same throughout the process.

3). If at some time I expect the Aussie dollar to depreciate but I expect the S&P 500 to go nowhere or down, I need to invest in a hedged US fixed income fund (rather than equities) but, as yet, I have not located a suitable US fixed income ETF. I’ll keep you posted.

4). If I see the yield play ending ‘soon’ – and I have two indicators to help me read the market – I will rebalance my hybrid portfolio into its new incarnation. Please recall that I produce a new hybrid portfolio each month but I only rebalance into the new one when significant events take place making it an efficient trade.

5). Since my hybrid portfolio strategy self-corrects into an appropriate balance – possibly across all sectors – this rebalance will require no other action in terms of what sectors and stocks to choose. In that sense, my hybrid strategy is dynamic.

6). My current ‘Other’ portfolio contains seven stocks in four groups. It is a legacy portfolio that I am slowly transitioning into my new strategy. In the first group, BHP and Rio will be sold down further if stock prices rise sufficiently and the proceeds will be put into the hybrid portfolio or the international portfolio as the then current conditions dictate.

7). Similarly, Santos and Woodside will follow the same rules as for BHP and Rio but I think oil price increases may not happen for some time and so I do consider these two stocks separately from BHP and Rio. Energy is a longer-term strategy.

8). CBA and Westpac form the third pair. I am likely to hold on to these stocks as very long term strategic plays. I much prefer these two banks from the big four – but nothing lasts forever. I did once own multiples of these stocks that I now own and I am now sitting on ballpark 100% capital gains. I find it hard to dismiss them.

9). Finally, Cochlear has been flying high of late. I typically buy Cochlear in the fifties and sell at just above $80. This strategy has served me very well over the last eight years. Its price has risen from about $72 to $81 in about a month. While I would normally sell some at this point, my anticipated fall in the Aussie dollar is likely to boost its earnings from exports. Secondly, it is still, in my opinion, recovering from a recall of a device (N5) a few years ago and I am anticipating better things from N6, which is still going through the process of adoption. Cochlear is very poorly rated by analysts (and has been for years) – but they did miss the last $30 improvement in the stock price! Moreover, the likes of CSL, Ramsay Health Care and Resmed in the health sector have made massive gains in recent times and investors might soon be looking for a new stock, such as Cochlear, in the same defensive sector but that is less over-priced.

So with my Plan B now firmly in place, I am about to start working on Plan C. I work on my strategy – for my own money – at least six days a week. There is a reason that fund managers want a management fee and, sometimes, an outperformance fee for doing this sort of work!

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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