Search for yield is not without risks but can they be managed?

17 March 2015

Self-managed super funds (SMSFs) have piled into the Australian sharemarket in recent years, driven by the search for yield as interest rates decline. But the huge focus on high-yielding stocks exposes SMSFs to heightened ‘concentration risk’, as well as to the normal equity risk of the sharemarket. Andrew Aitken, Bennelong Funds Management’s Head of Distribution, discusses.

Absolute return equity funds can help to hedge both kinds of risk, whether through an unconstrained high-conviction portfolio that differs greatly from the index, or the ability to potentially protect an investor’s downside through taking a high cash position, and even take ‘short’ positions to profit from market falls.

The SMSF revolution is the great unintended consequence of Australian superannuation (super) – no-one predicted that more than one million Australians would choose to run their own super. There is now almost $560 billion in SMSFs[1], which have grown to the point where they collectively hold the single largest dollop of the super pool.

Broking firm Credit Suisse estimates that since June 2005 the ‘selfies’ have ploughed $121 billion into shares – equivalent to one-third of net new equity issuance over the period. With about 32% of their assets held in Australian shares, Credit Suisse says SMSFs now own more than 16% of the Australian share market, or about $229 billion worth of shares. And financial industry research firm Investment Trends says 95% of SMSFs hold direct shares.

The recent massive growth in SMSFs has coincided with a heightened search for yield as interest rates have fallen. Term deposit interest rates have halved over the last four years, increasing the pressure on people who rely on income to fully – or partially – fund their retirement.

Many SMSFs have used the share market to fill this gap, leveraging the concessional tax treatment of super and the effectiveness of fully franked dividend income. This is about the only free-kick that the Australian Taxation Office (ATO) hands out – but it is a beauty.

Because super funds have a lower tax rate than the company tax rate of 30%, they receive cash rebates of the franking credits that they’re unable to use to offset their tax. If an SMSF is in ‘accumulation phase’, its tax rate is 15% and it gets a partial tax refund of $215 for every $1,000 of fully franked dividends it receives. For such investors, a dollar of fully franked dividend income is effectively worth more than a dollar.

It is even better when the SMSF moves to ‘pension phase’; that is, it is paying pensions to its members. The assets are held in the fund’s ‘pension account’, which means they are being used solely for the purpose of paying out a pension. In this instance, there’s no tax on the income or capital gains from the assets and the franked dividends can actually be refunded fully by the ATO. The fund gets a tax refund of $429 for every $1,000 of fully franked dividends it receives, which can turbo-charge the nominal dividend yield quite spectacularly.

For example, on market consensus forecasts, Telstra is expected to pay a fully franked dividend of 32.2 cents in FY16. At a share price of $6.60, that dividend would represent a nominal dividend yield of 4.9% – more than attractive when the official interest rate is 2.25%, and a one-year term deposit will pay you about 3.3%.

But to an SMSF in accumulation phase, that nominal yield of 4.9% becomes – courtesy of the partial franking credits rebate – effectively the equivalent of 5.9%. And to a pension-paying fund, receiving a full rebate of the unused franking credits, Telstra’s effective yield rises almost to 7%. In a low interest rate environment, that is a massive attraction.

SMSFs investing for yield in this way account for a massive chunk of the self-managed funds’ share of the sharemarket. Telstra and Commonwealth Bank are some of the SMSFs’ favourite stocks: as at their most recent annual reports, Telstra has 1.4 million shareholders, while CBA has 770,000.

Other popular blue-chip ‘income’ stocks include Westpac (596,000 shareholders), National Australia Bank (533,000), ANZ Bank (500,000), Wesfarmers (514,000) and Woolworths (441,000). Add BHP (555,000 Australian shareholders) and Rio Tinto (207,000 Australian shareholders) and you have about 60% of the Australian market’s value. That is unacceptably high concentration risk.

On their own, the big four bank stocks now account for more than 31% of the benchmark index. While these stocks’ 4.8%–5.5% nominal yields – that is 6.9%–7.9% for funds in pension phase – make them the bedrock assets of many SMSF portfolios, in reality, a big holding of bank shares makes a fund increasingly exposed to falling house prices, given that more than 40% of total Australian bank assets are home mortgages. It’s important that SMSF trustees do not lose sight of these kinds of factors, as well as the associated question of whether bank stocks are getting over-heated in price. A focus on yield will not do the investor much good if those stock prices fall.

Balancing this heavy exposure with an absolute return long/short ‘stock-picking’ fund that feels no compulsion to hold the banks or BHP – or any other stock – is one way of offsetting this risk. Here, you’re backing the manager to build a diverse portfolio – comprising both big and small companies – that can out-perform the index. The absolute return strategy may also be able to reduce overall portfolio volatility and go ‘short’ – either to make money or hedge its ‘long’ exposure.

Where an SMSF investor – or a long-only equity fund – simply picks stocks to own, the absolute return fund could be picking stocks to sell short, opening up a return stream not correlated with the index which can generate returns if the market falls. By all means, in a straitened environment for income, SMSFs can use fully franked dividends as a viable source of income. However, they should also look to have equity investments that can hedge the equity and volatility risks of the concentrated holding that a yield focus tends to build-in to an Australian share portfolio…and absolute return strategies can fit this bill nicely.