Are SMSFs better investors; or beneficiaries of a free ride?

SMSFs’ net assets have grown as fast or even faster than Large Super over recent years; and their investment returns have been vastly better. There is a simple explanation for this — and it’s one that you can be sure Treasurer Chalmers is all over.

It isn’t supposed to be this way.

Australia’s army of self-managed super fund (SMSF) proprietors hold very little in overseas shares; and they hold a great deal of cash; in comparison to the professionally managed portfolios of big super funds.

But the performance of the SMSFs streets that of the big super funds. How?

According to Tim Toohey, head of macro and strategy at Yarra Capital Management, the SMSFs exhibit an “almost complete rejection of international assets” in their asset allocations, and “a seemingly unhealthy obsession with relatively low-yielding cash deposits.”

Just 3 per cent of SMSF assets are allocated to offshore investments, and a massive 16 per cent of assets are allocated to cash. In comparison, larger super funds allocate 38 per cent of their assets to offshore investments, and hold just 9 per cent in cash. Also, SMSFs hold significantly more in Australian shares (27 per cent) than Large Super does (22 per cent).

Given the strong performance of global equities in recent years, it is reasonable to assume that returns in the home-biased SMSFs would have underperformed the larger – and presumably more professionally run – superannuation funds.

But Toohey has crunched the data; and it tells a different story.

As at the end of the December 2024 quarter (the most recent data available), SMSF net assets totalled $981 billion, having risen an impressive 38 per cent over the prior four years.

APRA’s superannuation statistics for Large Super showed total net assets stood at $2,986 billion as at the end of the December 2024 quarter, having also increased 38 per cent (in this case, over the prior five years).

“Despite their conservative cash holdings and extreme domestic focus, SMSFs have grown just as fast as their larger and more sophisticated cousins, and now represent 25 per cent of total superannuation assets,” says Toohey, who asked himself the obvious question – how is this possible?

There are four conventional ways this could happen, he says:

(i) if SMSFs were attracting a greater share of younger members. But no, he says, this is not happening.

(ii) if large and increasing numbers of Large Super were taking their rollovers and shifting into SMSFs. This is happening, he says, but is not a big contributor.

(iii) if there were an income and age skew to SMSFs that generate net inflows above the rate of the super system in general. No – Toohey found that SMSFs are actually in large net outflow, even after accounting for rollovers from Large Super.   

(iv) superior asset allocation decisions.

Toohey looked at proposition (iv) in detail.

Over the period 2019-20 to 2022-23, SMSFs grew net assets by 30 per cent, exceeding growth in Large Super by 3.5 percentage points.

Stripping-out the impact of rollovers and contributions, he found that SMSFs achieved a 34 per cent investment return as reported by the Australian Taxation Office (ATO), compared to 20 per cent for Large Super – a 14 percentage-point (that is, 70 per cent better) difference, in just three years.

How was it possible, asks Toohey, that individual (or ‘mum and dad’) investors running SMSFs achieved vastly better investment returns than professional Large Super investment teams?

Using the differing asset allocation weights of SMSFs and Large Super and the returns of each asset class in A$, Toohey tested how much of this superior investment return by SMSFs is due to asset-class selection. Applying asset-class weights and asset-class returns, he found that the reported 20 per cent return over the three years to 2023 by Large Super checked out. But in doing the same exercise for SMSFs, he found the asset allocation choices for SMSFs generated a return of 23 per cent – slightly better than Large Super, but well short of the 34 per cent investment returns reported by the ATO.

“Asset allocation provided a modest benefit to SMSFs over the three-year period – despite them virtually ignoring the booming international shares asset class. But the combination of asset allocation choices and asset-class returns was not enough to explain the 11 per cent difference between the investment returns achieved by SMSFs and Large Super over the three-year period,” says Toohey.

So, what explains it?

“By a process of elimination, there really is only one factor left that can explain (the 11 per cent difference),” says Toohey. “It’s tax.”

Quite simply, SMSFs harvest far greater tax benefits than Large Super.

SMSFs have a far greater proportion of members in the tax-free retirement or pension phase where no tax is paid, thus boosting total SMSF returns. Toohey estimates that this provides a 1.7 per cent a year boost (or 5 per cent over three years) to SMSF growth.

“Also, the SMSFs are using more tax-advantageous strategies during the accumulation phase, that have generated approximately 2 per cent per annum additional return compared to Large Super over the last three years,” he says.

For example, a larger weighting to domestic listed equities (27 per cent in SMSFs compared to 22 per cent in Large Super) suggests that SMSF members are likely to be benefiting disproportionately from targeting franked dividends, and in particular, the refunded franking credits for 15 per cent and zero tax rates. “We estimate that this explains over half the 2 per cent per annum additional return, a very meaningful contribution particularly when compounded over time,” says Toohey.

Other options are also available to SMSFs that are likely being targeted. Currently, 6 per cent of SMSF assets are in residential property. The ability to use leverage to purchase residential property inside a SMSF affords negative gearing strategies that cannot be accessed via Large Super. Moreover, the use of tax-effective special investment vehicles – which the Federal Government has championed to direct investment towards high-technology startups and smaller businesses – provide another avenue for SMSFs to minimise tax during the accumulation phase which is not possible for Large Super to access in scale.

SMSFs have a much high share of members approaching retirement and likely to be skewed to highly beneficial franked dividend income streams, negatively geared property and tax-friendly investment vehicles “By deduction, we estimate that this benefit to SMSF returns from these investments is currently approximately 1.7 per cent per annum,” says Toohey.

“SMSFs are not better investors than Large Super funds: the asset allocation investment returns are similar to Large Super, but they are older and more tax-wise,” he says. “SMSF members are enjoying relatively more of the benefit of the tax-free pension phase of retirement and are better able to skew their investment strategy towards tax-friendly retirement strategies, which has greatly enhanced both their investment returns and aggregate SMSF asset balances.”

The obvious question from Toohey’s work is, will the federal Treasurer now reset his sights on the tax benefits afforded to the superannuation sector in general, and the SMSF sector in particular?

“We think the answer is yes, but with one-quarter of superannuation assets now in SMSFs and 1.2 million members it will not be a popular decision,” says Toohey. “SMSFs are clearly better for higher-income Australians with access to a good tax accountant. But whether this results in a more dynamic and equitable economy is a separate open question altogether.”