Managing a self-managed super fund (SMSF) gives trustees greater control over how retirement savings are invested. However, greater control also comes with important responsibilities, particularly when borrowing is involved.
The idea behind SMSF Diversification Loans is often connected with using finance as part of a broader investment strategy. However, borrowing through an SMSF is subject to strict superannuation rules, and a loan does not automatically make a portfolio more diversified or less risky.
Under Australian superannuation law, SMSFs are generally prohibited from borrowing money except in limited circumstances. One of the main exceptions is a limited recourse borrowing arrangement (LRBA), which can allow an SMSF to borrow to acquire a permitted single asset, subject to specific requirements.
For SMSF trustees considering borrowing, the important question is not simply how much they can borrow. It is whether the proposed investment and loan structure fit the fund’s investment strategy, cash flow requirements, risk profile, and retirement objectives.
What Are SMSF Diversification Loans?
“SMSF Diversification Loans” is not a specific loan category under Australian superannuation law. Rather, the term can be used to describe borrowing considered as part of an SMSF’s broader investment and diversification strategy.
Diversification means spreading investments across different assets, sectors, markets, or investment types to reduce the effect of one investment performing poorly. MoneySmart explains that diversification can reduce portfolio volatility because different investments may perform differently under changing market conditions.
However, SMSF borrowing works differently from ordinary investment borrowing.
Under an LRBA, an SMSF can generally borrow to acquire a single asset or a collection of identical assets that have the same market value and that are held in a separate trust. The arrangement must satisfy the relevant superannuation rules.
This means trustees should not assume they can simply take an SMSF loan and use the borrowed money to purchase a broad selection of shares, ETFs, property, and other investments.
The structure, purpose, and asset being acquired all matter.
Why Does Diversification Matter for an SMSF?
Diversification is an important consideration when developing an SMSF investment strategy.
The Australian Taxation Office (ATO) states that an SMSF investment strategy must consider the composition of the fund’s investments, including the extent to which they are diversified and the risks of inadequate diversification. The strategy must also consider liquidity, expected returns, risks, and the fund’s ability to pay member benefits and other costs.
For example, an SMSF heavily concentrated in one investment may be exposed to greater risk if that investment experiences a significant decline in value.
Diversification can potentially involve exposure to different:
- Asset classes
- Companies
- Industries
- Geographic markets
- Investment styles
- Income-producing assets
- Growth-oriented investments
The appropriate mix depends on the fund and its members.
Diversification is therefore not about simply owning as many investments as possible. It is about constructing an investment mix that reflects the fund’s objectives, risk tolerance, liquidity needs, and retirement timeframe.
How Can Borrowing Fit Into an SMSF Investment Strategy?
Borrowing can increase the amount of capital available for an investment, but it also increases financial obligations.
For an SMSF, this means the investment strategy should be considered before entering into an LRBA.
The ATO says an SMSF investment strategy should be tailored to the fund’s circumstances and should explain how investments meet members’ retirement objectives. It should consider the risks and likely returns, liquidity, cash flow requirements, and diversification.
For example, an SMSF may already have substantial exposure to property. Taking on additional debt to purchase another property could increase concentration rather than improve diversification.
On the other hand, an SMSF with a different asset allocation may have different diversification considerations.
This is why borrowing should be assessed as part of the entire portfolio rather than viewed as an isolated financing decision.
SMSF Property Loans and Portfolio Diversification
Property is one area where SMSF borrowing is commonly discussed.
An SMSF can, subject to the relevant rules, use an LRBA to acquire certain residential or commercial property. MoneySmart notes that SMSF property investments must satisfy requirements, including the sole purpose test and restrictions on acquiring or using residential property involving members or related parties.
For business real property, different rules can apply, including circumstances where an SMSF can lease the property to a related business at market rates.
However, property can be a large investment relative to the overall SMSF balance.
This creates an important diversification consideration.
For example, if most of an SMSF’s assets are already invested in property, borrowing to purchase another property may increase concentration. It could also reduce liquidity because property generally takes longer to sell than listed investments or cash.
MoneySmart specifically warns that SMSF property borrowing can create higher costs, cash flow pressure, loan repayment risk and difficulties if the arrangement needs to be unwound.
Can Borrowing Actually Reduce Investment Risk?
Borrowing itself does not reduce investment risk.
In fact, leverage can increase both potential gains and potential losses. MoneySmart describes borrowing to invest as a high-risk strategy because investors still have to repay the loan and interest even if the investment falls in value.
This is particularly important when considering an SMSF.
Suppose an SMSF borrows to acquire an investment and that investment subsequently falls in value. The fund still has its repayment obligations.
There may also be periods when the investment produces less income than expected.
For property, for example, vacancy can reduce rental income while loan repayments and other expenses continue.
Therefore, the role of borrowing should be considered separately from diversification:
Diversification can help spread investment exposure. Borrowing increases exposure and financial obligations.
Combining the two requires careful planning.
Liquidity Is an Important Consideration
An SMSF needs sufficient liquidity to meet its obligations.
These may include:
- Loan repayments
- Investment expenses
- Accounting and administration costs
- Insurance
- Tax obligations
- Pension payments
- Member benefits
- Unexpected expenses
The ATO specifically requires SMSF investment strategies to consider the liquidity of fund assets and the fund’s ability to pay benefits and other costs.
This becomes particularly important when an SMSF holds an illiquid asset such as property.
A diversified portfolio may contain a mixture of assets that can be converted to cash at different speeds. Trustees should consider whether the fund could continue meeting its obligations if an investment cannot be sold quickly.
Costs Can Affect the Benefits of Borrowing
Before considering an SMSF loan, trustees should look beyond the interest rate.
Borrowing can involve:
- Loan establishment costs
- Interest
- Legal costs
- Trust establishment costs
- Valuation costs
- Accounting fees
- SMSF administration expenses
- Property management costs
- Insurance
- Maintenance and other investment expenses
MoneySmart notes that SMSF property investments can involve setup costs, ongoing SMSF and property costs, loan costs, and other expenses. These costs ultimately reduce the amount available within the fund.
The overall cost of the strategy therefore needs to be considered alongside the expected investment return.
Your SMSF Investment Strategy Comes First
A loan should not determine an SMSF’s investment strategy.
The investment strategy should come first, with any proposed borrowing assessed against it.
Trustees should consider questions such as:
- What are the members’ retirement objectives?
- What is the fund’s current asset allocation?
- How diversified is the portfolio?
- What level of investment risk is appropriate?
- How much liquidity does the fund require?
- Can the fund continue meeting repayments if investment income falls?
- What happens if interest rates increase?
- What happens if the investment decreases in value?
- How will member benefits be funded?
- Are the proposed costs sustainable?
These questions can help identify whether borrowing fits the overall structure of the SMSF.
Why Professional Advice Matters
SMSF borrowing can involve superannuation law, investment considerations, taxation, lending requirements, and legal documentation.
ASIC states that when recommending an LRBA, advisers should ensure clients understand the associated risks and why the arrangement is appropriate for their circumstances.
ASIC’s recent review of SMSF establishment advice has also highlighted the importance of considering clients’ individual circumstances, the risks and costs of SMSFs, and alternatives to particular strategies.
For this reason, SMSF trustees should obtain appropriate professional advice before establishing an SMSF borrowing arrangement.
A finance broker can help with lending and finance options, while registered financial advisers and other appropriately qualified professionals can provide advice within their authorised areas.
How JH Finance Group Can Help With Your Finance Requirements
At JH Finance Group, we understand that financing an investment can involve more than simply comparing interest rates.
Our role as a finance broker is to help clients consider available lending options based on their circumstances and finance requirements.
If you are considering borrowing in connection with an SMSF investment, it is important to have the appropriate financial, taxation, and legal advice alongside any finance discussion. The lending structure needs to work within the applicable SMSF rules and the fund’s broader strategy.
Conclusion
SMSF Diversification Loans can be an important topic for trustees considering how finance may fit into their investment strategy, but borrowing should never be viewed as a shortcut to diversification or risk reduction.
Diversification involves spreading investments across appropriate assets and markets, while borrowing introduces additional financial commitments. An SMSF investment strategy needs to consider both concepts alongside liquidity, cash flow, investment risk, expected returns, and members’ retirement objectives.
For SMSF property borrowing, an LRBA can provide a structure for acquiring eligible assets, but it also introduces costs, complexity, and repayment obligations. The fact that an SMSF can borrow does not necessarily mean borrowing is appropriate for every fund.
Before making a decision, review your existing portfolio, understand how a proposed investment would affect diversification, assess the fund’s ability to meet repayments, and consider the potential impact of changing investment values and interest rates.
If you are exploring finance options for an SMSF-related investment, JH Finance Group can assist with the finance side of the process. Speak with appropriately licensed financial and professional advisers about whether the strategy itself is suitable for your SMSF before proceeding.
