SMSF – Investment Strategy – deals with ATO’s position on ‘diversification’

What is an Investment Strategy?

An SMSF Investment Strategy is a documented plan for making and holding the assets of a Self-Managed Superannuation Fund (SMSF). It outlines how the SMSF manages its investments to meet its members’ retirement objectives. Legal Consolidated’s SMSF Investment Strategy allows for up to six members.

Key Features of an SMSF Investment Strategy:

1. Purpose: The strategy must demonstrate how the fund will meet its members’ retirement and financial goals.
2. Considerations: It must take into account:
   • Risks associated with the fund’s investments.
   • Expected returns.
   • Liquidity (how easily assets can be converted to cash to meet obligations like pension payments).
   • Diversification (to avoid concentration risks, though diversification is not strictly mandated).
   • Ability to pay benefits and other costs.
   • Insurance needs of the members (such as life or TPD insurance).
3. Tailored to the Fund: The strategy must be specific to the circumstances of the fund and its members (e.g., age, employment status, financial goals).
4. Regular Review: It must be reviewed and, if necessary, updated at least annually or whenever significant events occur (e.g., market corrections or changes in members’ circumstances).
5. Documentation: The strategy must be in writing and provide evidence of actively considering the relevant factors.
6. ATO Requirements: Broad investment ranges (e.g., 0%-100%) are discouraged unless justified. Trustees must show they have actively considered and applied the strategy.

The strategy should not dictate what investments are permissible but rather explain the fund’s approach to investing to achieve its goals. It serves as a practical guide for trustees and ensures compliance with superannuation laws.

How often must an SMSF Investment Strategy be updated?

As circumstances change, the Investment Strategy must be reviewed and updated at least annually, and the Minutes contained within this document are your evidence of this. 

The law requires that all Self-Managed Super Funds have an investment strategy. This strategy helps the trustee decide how to invest in the members’ best interests.

Our Investment Strategy is fully compliant with Commonwealth legislation and contains Minutes for the Self-Managed Super Fund to adopt the Investment Strategy, as well as a letter from our law firm for your accountant and your auditor’s due diligence file.

The Australian federal government provides generous tax concessions that come from operating a ‘compliant’ self-managed superannuation fund (SMSF).

SMSF Investment Strategy compliant with ATO, auditor and Banking Royal Commission

The Legal Consolidated SMSF Investment Strategy is continually updated based on the ATO desktop audits we attend and ongoing consideration of ATO rulings and Court cases. When the ATO’s position changes (both public and private), we update the SMSF Investment Strategy.

To ensure your SMSF Investment Strategy remains current, build the SMSF Investment Strategy each financial year.

The SMSF Investment Strategy is designed to comply with SIS Legislation, the ATO’s current requirements, the Banking Royal Commission, and the best practices of your SMSF auditor.

Is an SMSF Investment Strategy a legal requirement?

It is a legal requirement under the Superannuation Industry (Supervision) Act 1993 (SIS Act) and related regulations.

Must an SMSF Investment Strategy be in writing?

Yes, an SMSF Investment Strategy must be in writing. This is a legal requirement under Regulation 4.09 of the Superannuation Industry (Supervision) Regulations 1994.

The four reasons why an SMSF Investment Strategy must be in writing:

1. Evidence of Compliance: A written strategy provides evidence that the SMSF trustees have considered all the relevant factors required by law, such as risk, diversification, liquidity, and insurance needs.
2. Review and Updates: Trustees can regularly review and update the strategy, ensuring it remains relevant to the fund’s circumstances.
3. Audit Requirements: The written strategy is reviewed during the fund’s annual audit to confirm compliance with superannuation laws.
4. ATO Oversight: The Australian Taxation Office (ATO) requires trustees to demonstrate that they have implemented and are adhering to the strategy.

Failing to have a written strategy results in penalties and non-compliance with superannuation laws. Trustees should ensure the document is tailored to their fund’s specific circumstances and updated whenever necessary.

What help does the ATO give you in preparing an SMSF Investment Strategy?

The Australian Taxation Office’s investment strategy fact sheet for SMSF trustees emphasises compliance significantly. Trustees are instructed that the fund must comply with the SIS Act, Section 52(2)(f), by:

1. Investing to maximise member returns while considering the risks associated with holding investments.
2. Ensuring appropriate diversification across asset classes (such as shares, property, and fixed deposits) as part of a long-term investment strategy.
3. Maintaining the superannuation fund’s ability to pay benefits and other costs as they become due.

While these requirements are outlined, the remainder of the document focuses on compliance issues. It lacks detailed investor education or practical guidance for SMSF trustees on effectively achieving these objectives. As a regulator, this is appropriate. It is your accountant, auditor and financial planner that help with how to achieve these goals.

Is it acceptable to have 90% of your SMSF in one asset?

The ATO attacks SMSFs that have most of their wealth in one asset.  About 17,700 self-managed super funds hold 90% or more of their funds in one asset or a single asset class. The ATO is concerned:

1. Have the trustees considered diversifying their fund’s investments? If not, this can put the fund’s assets at risk.
2. Lack of diversification or concentration risk can expose the SMSF and its members to unnecessary risk if a significant investment fails.

The last time I checked, the ATO was not licenced to give financial planning advice. Why is the ATO getting involved in areas without skill or permission to do so? Whether a portfolio’s diversification is appropriate is a question for your financial adviser, not a tax collector.

The ATO asks trustees to review their investment strategy to ensure it complies with regulation 4.09 SIS Regs. Regulation 4.09 asks you to consider diversification, not to be diverse.  Like the insurance consideration, an SMSF is not required to hold life insurance. It just has to consider whether it should. The ATO asks trustees to prepare their investment strategy for their SMSF’s auditor for their next audit. According to the ATO, ‘this is to help the auditor form an opinion on the fund’s compliance with these requirements’.  Sorry ATO.

Auditors have already been burdened enough. They are not in the business of being financial planners—they audit.

Nothing in the superannuation law prevents your SMSF from holding 90% or more of its funds in one asset or a single asset class. Take a look at section 52B(2)(f) SIS Act. It merely requires each SMSF to “formulate, review regularly and give effect to” an investment strategy that has regard to the whole of the fund’s circumstances, including the factors set out in reg 4.09(2) SIS Regs. Now, that does include the risks from inadequate diversification.

On the face of it, it is, therefore, perfectly acceptable for an SMSF to invest 100% of its funds in a single asset. Consider, for example, business real property or 100% in the Australian Securities Exchange. However, the SMSF trustees ensure that the investment strategy allows this. Legal Consolidated’s investment strategy does. Our investment strategy has regard to the additional risks from such “inadequate” diversification in terms of:

1. the likely return from the investment with regard to the fund’s objectives
2. liquidity
3. expected cash flow requirements and
4. the ability to discharge its existing and prospective liabilities (e.g. benefit payments).

Diversity of the Member’s SMSF

Holding several investments is the essence of diversity. This may have the effect of reducing volatility. However, it is best to speak with your financial planner and accountant because diversification is only one factor to be considered in a fund’s investment strategy.

Diversification is a risk management strategy that mixes various investments within a portfolio. The rationale behind this technique is that a portfolio constructed of different kinds of assets may, on average, yield higher long-term returns and lower the risk of any individual holding or security. Alternatively, your financial adviser may be of the view it just waters down returns.

Managing many assets involves higher holding costs. Warren Buffet says:

“Wide diversification is only required when investors do not understand what they are doing.”

History has shown that diversification has not necessarily saved investment portfolios. In fact, without the aid of a financial planner, it is more likely, not less likely, that the SMSF may take a substantial loss at some point. The truth is that the fund cannot avoid losses. The fund sometimes takes losses in the investments, whether they are diversified or not. Don’t listen to the ATO’s ‘financial planning’ advice on ‘diversification’. Instead, speak to your financial adviser and accountant.

Disadvantages of Diversification in a Self-Managed Superfund’s Portfolio

1. Diversity in an SMSF reduces Quality

There are only so many quality companies, and even fewer are priced at levels that provide a margin of safety. Thus, the more stocks you put into the fund portfolio, the less concentrated it is in the best opportunities.

2. Too Complicated

A fund portfolio can include so many assets that the fund does not fully understand what is in them. While diversification in investing is important, a simple portfolio is often easier to manage.

3. Indexing

If the SMSF has too many assets in its portfolio, it becomes an index fund.

The more shares the fund owns, the more correlated the portfolio is to stock market returns. (Which may lead to a lack of diversification.)

4. Below Average Return

Indexing and over-diversification may be disadvantages of diversification because quality suffers when you own inferior and good investments. Below-average returns result from transaction fees or high fund fees.

5. Balance assets outside of the Superannuation fund

Only members with their financial planners have a complete picture of their overall assets—both in and out of the superannuation fund. Assets in the fund can balance assets out of the fund. If you and your adviser feel you are overweight in equities out of your super, then non-equity assets in your super may be appropriate. If you want to live on the Gold Coast after retirement, then it may be appropriate that your superannuation hold that Gold Coast retirement home for the moment.

Most of my SMSF assets are in the same class – what do I give my accountant and auditor?

Q: Management Letter: I have been sent a management letter requesting minutes for the meeting detailing my investment strategy. Because I have a large proportion of the fund’s assets in one class (physical metals), I must include your cover letter (the first three pages) in this submission of my investment strategy minutes and diversification statement.

A: I would include the entire letter that our law firm gives you when you develop this year’s Investment Strategy. It sets out our interpretation of the current rules and shows that you received legal advice, which may comfort your accountant and auditor. However, you must provide your own diversification strategy, which your accountant and financial planner will help you with.

These factors in our Investment Strategies are considered:

1. diversification of the fund’s investments
2. the risks associated with inadequate diversification within the context of the fund’s investment portfolio
3. the making, holding and realising and the likely return from the fund investments having regard to the member’s retirement objectives and expected cash flow requirements
4. the liquidity of the SMSF investments, including the ability of the fund to pay benefits as members require and pay other costs incurred by the fund
5. whether to hold insurance coverage for members of the fund from time to time

What is an SMSF Investment Strategy?

An Investment Strategy is a plan for making and holding the Self-Managed Super Fund’s assets.

As circumstances change, it is important that the Investment Strategy is reviewed and updated at least annually, and the Minutes contained within this document are your evidence of this. 

The law requires that all Self-Managed Super Funds have an investment strategy. This strategy helps the trustee decide how to invest in the members’ best interests.

Our Investment Strategy is fully compliant with Commonwealth legislation. It contains Minutes for the Self-Managed Super Fund to adopt the Investment Strategy and a letter from our law firm confirming that you have built a compliant Investment Strategy. It complies with SIS Regulation 4.09 and the case of Cam & Bear Pty Ltd v McGoldrick [2018] NSWCA 110. Most auditors require this to protect them from section 55(3) SIS Act 1993 prosecution.

The Australian federal government provides generous tax concessions that come from operating a ‘compliant’ self-managed superannuation fund (SMSF).

Legal Consolidated produces investment strategies that comply with the latest ATO rulings each financial year.

We ensure that your SMSF’s investment strategy:

1. is in writing
2. complies with the legal requirements and trust deed provisions
3. has been implemented accordingly and documented in the meeting minutes
4. is reviewed at least annually, and
5. any changes are documented in meeting minutes.

What does your SMSF Auditor need to see?

SMSF auditors ensure that appropriate audit evidence is obtained to show that an SMSF has a compliant investment strategy (Regulation 4.09 SIS Regs) that considers the fund’s circumstances, including risk, return, liquidity, diversification, and any insurance needs. We prepare such Investment Strategies each year.

Auditors fed up with ‘fake’ SMSF Deeds

Non-law firms are preparing SMSF Deeds and variations. This is probably illegal. But they argue that they are merely reselling an SMSF Deed that they got from a law firm. Sadly, the law firm Professional Indemnity Insurance does not cover these ‘resold’ legal documents. Accountants, auditors and clients are exposed. To protect themselves, auditors require that you update your SMSF Deeds directly with a law firm’s website. You can do that here.

Over 4,800 Australian accountants and advisers build legal documents on our website. This is for their clients. Because we are a law firm, their client becomes a client of the law firm. Legal Consolidated is responsible for the documents that you build on our website.

In contrast, a non-law firm website:

• merely resells a lawyer’s template; and
• therefore, there is no law firm protecting or responsible for the document

Is building an SMSF Investment Strategy giving financial planning advice?

To give advice on superannuation and SMSF funds you need either a limited or full Financial Services Licence. For example, such licences are required when recommending the setting up of an SMSF, starting a pension, commutations and giving advice on an SMSF Investment Strategy.

On our law firm website for your clients, you build:

• SMSF Deed – each comes with the latest Investment Strategy
• Special Purpose Company – to be trustee of SMSF
• Binding Death Benefit Nomination – updates the SMSF Deed as well
• SMSF Commercial Lease Agreement
• Deeds of Variation – Change Trustees & Members, Update Deed for new SIS Laws
• Product Disclosure Statement – fully compliant with budget
• SMSF Investment Strategy

All documents come with our law firm’s cover letter stating that we authored them, not you. We are responsible for each document. Indeed, just as a law firm cannot give financial planning advice or prepare tax returns, only lawyers can provide ‘Deeds’.

Since 1994, we have provided SMSF Deeds (with Investment Strategies) and standalone Investment Strategies each year.

When you build an SMSF Deed or an Investment Strategy, we are responsible for the document, not you. In our view, providing such documents does not constitute advice regarding the Financial Services Licencing rules. However, they are the law firm’s documents, and you are not responsible for them.

Investing in Cryptocurrency using SMSF

Legal Consolidated SMSF deeds allow for the new Cryptocurrency rules see here.

What date do you sign the SMSF Investment Strategy minutes?

Q: Signing: At the bottom of the minute document, above the space for the trustees to sign, it says:

“Unless stated otherwise, each signature below was affixed on the date of the meeting.”

In my case, the meeting took place on 28 January. However, I am now resubmitting the investment strategy I purchased from you. Do I need to sign/date it any differently?

A: We first produced the SMSF Investment Strategy in 1988. We update it each financial year, so you should build a new one each year. However, it is common for the Legal Consolidated Investment Strategy to be signed several times throughout the year. Reviewing and signing an Investment Strategy quite often looks good and confirms that you care about investment strategies. Date the minutes with the date you sign the Investment Strategy.

SMSF’s life Insurance, Total Permanent Disability and other insurance

Q: Do I need to include an additional note for life insurance decisions in my submission for the management letter? 

A: You should work with your life insurance adviser on what insurance you must hold (e.g., artwork). Everyone is different. For example, if you are a father with a stay-at-home wife and five young children, you may need more life and TPD insurance.

If your accountant, adviser, auditor, and lawyer decide that such policies or minutes must be in writing, attach them to the Investment Strategy. Update them at least once a year, and if your circumstances change, more often throughout the year.

Cam & Bear Pty Ltd v McGoldrick [2018] NSWCA 110

The facts of Cam & Bear Pty Ltd v McGoldrick [2018] NSWCA 110 are: 

Dr Bear is a member of his SMSF. He has a friend named Mr Lewis, who works at Lewis Securities.

Dr Bear provides regular contributions to the SMSF. This is via cheques payable to Lewis Securities.

Dr Bear believes that from 1996 to 2008, his SMSF was in cash and shares.

Dr Bear’s auditor has a similar view. And provide unqualified audit reports, accordingly.

They stated that the financial statements fairly reflected the Fund’s financial position. The auditor did not communicate directly with Dr Bear.

On 22 September 2008, Dr Bear directs Mr Lewis to withdraw some cash from the SMSF.

Mr Lewis is reluctant to do so, so conveniently, Lewis Securities goes into voluntary administration. There is no money.

What the court said in Cam & Bear Pty Ltd v McGoldrick

Who is responsible for Dr Bear’s loss: Dr Bear or the auditor?

Dr Bear (mostly) wins.

• Even with his lack of financial sophistication, Dr Bear should have considered the prudence of giving large amounts of money to Mr Lewis. Dr Bear is silly. He should have been smarter. 
• However, the auditor’s negligence is the main cause of the SMSF’s loss.

Accordingly, the loss is apportioned: 10% to Dr Bear’s SMSF, and the other 90% is appointed to the SMSF’s auditor.

The auditor owed a duty of care to the SMSF. This duty is to exercise reasonable care, skill, and diligence to ensure that the audited financial report fairly describes the circumstances.

The financial statements did not give a fair representation of the affairs of the SMSF. Therefore, it is incumbent upon the auditor to either:

• qualify the report;
• or bring to the SMSF trustee’s attention to the problem.

Ryan Wealth Holdings Pty Ltd v Baumgartner 

The facts of Ryan Wealth Holdings Pty Ltd v Baumgartner [2018] NSWSC 1502: 

The Ryan Holdings Retirement Fund lodges three financial returns. These are for FY07, 08 and 09.

The Ryan Holdings Retirement Fund is established. It invests in loans to various entities and investments in unit trusts. Sadly, the professional adviser is interested in some of these investments. 

The SMSF financial statements show these as ‘mortgage loans’.

• • However, there are no mortgages. The information provided to the SMSF auditor contained no evidence of mortgages, and no encumbrances over any of the assets have been registered.
  • The auditor fails to try and find evidence of a mortgage.

In all 3 financial years, the auditor merrily gave the SMSF unqualified audits.

The SMSF argues that the auditor failed to check on the mortgages. And, therefore, they went undetected.

By the time the SMSF discovers that there are no such securities, it is too late.

The decision of Ryan Wealth Holdings Pty Ltd v Baumgartner

The Court states that the auditor fails to exercise reasonable care and skill:

• this is to ensure that the investments are valued at net market value
• fails to exercise judgment in assessing the reasonableness of the disclosed values
• the auditor has a duty to report to the SMSF about the professional adviser’s obvious conflict of interest and the high risk associated with the loans and investments.

The Court assesses damages of $2,260,140.

The Court looked at the chances of the unsecured loans being paid back.

Responsibility for the loss is apportioned 10% to the SMSF. And 90% to the auditor. Further, the Court states that the SMSF’s loss is apportioned to the professional adviser as 20%.

What do we learn from Cam & Bear v McGoldrick and Ryan Wealth v Baumgartner?

That was a tough year for auditors.

But these two cases, Cam & Bear and Ryan Wealth Holdings highlight, not only highlight risks to SMSF auditors. They are also warnings to financial planners, accountants and lawyers.

6 best practices to follow for an SMSF’s financial reports:

1. Work out who is the key contact at the SMSF. That person sees all communications. This is particularly where instructions are being provided by another person. Whatever the accountant, financial planner, and auditor state should be cc’d to the key contact. And when in doubt, email all members of the SMSF (and the SMSF’s corporate trustee, if a corporate trustee).
2. In your instructions, make it clear to your client, the SMSF, that you are not doing certain things. For example, the accountant preparing the SMSF tax returns is not an auditor. The accountant does not test the information provided. But still, point out problems wherever you see them.
3. Mistakes and errors are common. To err his human. When they are uncovered, be ready to engage the ‘team’.
4. Only lawyers can give legal advice, accountants can handle certain matters, and financial advisers can advise financial planning (e.g., reversionary pensions). If you stray outside your professional area, your insurance stops. Work with your team.
5. Emails and a chain of emails are good insurance.
6. Sack clients that are on the edge lie to you or want you to lie. The first person to dob you in is your client when a regulator comes knocking.