Investment strategies - the latest

If there was a single document that gave us angst over the past year it was the fund investment strategy!  Since we highlighted the difficulties for auditors and how the audit landscape was changing back in December 2018, we have navigated the last 9 months with uncertainty.  Our general observation being that the expectation of the ATO and the courts in relation to the investment strategy, far surpasses the attention given to the document by most in the industry in the past.

Late in the financial year the ATO investigated providing guidance on auditing regulation 4.09. We eagerly anticipated the publication of such guidance as we believed it would provide much needed clarity for the industry of the ATO’s minimum expectation.  We thought it may even raise the quality of strategies out there to be a more valid, authentic document.

However, in recent weeks we have been made aware the ATO has abandoned their plans to provide this guidance to auditors.  Alas, the draft guidance circulated to stakeholder groups had in fact resulted in greater confusion and apparently a deviation from the original intention of the ATO. 

Instead, the ATO believed a targeted approach in which they would contact 17,000 funds with concentrated assets (90% or more in the one asset or asset class) combined with an LRBA would be more effective.  Lack of diversification in a fund’s investment strategy is now the focus of the Regulator.

From the ATO’s perspective, a high concentration of assets in the one area could expose the SMSF, and therefore its member(s), to unnecessary risk if a significant asset fails.  However, contrary to some industry commentary, the ATO is not attempting to ensure all SMSFs are diversified.  Instead they are simply seeking to ensure the SMSFs which are not diversified, have considered the potential risks from inadequate diversification in their investment strategy as is required by regulation 4.09.  In addition to contacting these trustees, the ATO will write to the auditor of these funds to remind them of their obligations when auditing the document.

The requirements of regulation 4.09

Looking at the governing legislation on investment strategies, regulation 4.09, let’s consider what the auditor is required to assess. Specifically, the strategy needs to cover the following:

The trustee of the entity must formulate, review regularly and give effect to an investment strategy that has regard to the whole of the circumstances of the entity including, but not limited to, the following:

(a)  the risk involved in making, holding and realising, and the likely return from, the entity's investments, having regard to its objectives and expected cash flow requirements;

(b)  the composition of the entity's investments as a whole, including the extent to which they are diverse or involve exposure of the entity to risks from inadequate diversification;

(c)  the liquidity of the entity's investments, having regard to its expected cash flow requirements;

(d)  the ability of the entity to discharge its existing and prospective liabilities;

(e)  whether the trustees of the fund should hold a contract of insurance that provides insurance cover for one or more members of the fund.

Put simply, at a minimum the strategy must contain the above elements.  We believe if the wording above is included in the document, most investment strategies would sail through their audit with little issue provided all parts are satisfied.

When you look closely at the regulation, complying is actually a three-part process:

  1. Formulate
  2. Review
  3. Give effect

In our opinion, formulate means to prepare an investment strategy with implementation occurring through its adoption via a trustee minute.   Once in place, an annual review should be conducted (unless the circumstances of the fund change mid-term).  Giving effect, in practice is operating the fund in accordance with what is stated in the strategy.  For example, assets should conform with the strategy’s prescribed asset class ranges.  Other elements, such as borrowing must be considered in the strategy if the trustees wish to enter into an LRBA.

Where to from here for Baumgartner Super?

We will continue to closely review all investment strategies to ensure they meet the minimum requirements of the regulation.  Some strategies we see, including widely used industry templates, don’t contain all the elements of the legislation. Therefore, now is the time to revisit your clients’ strategies to identify any deficiencies.

Where a fund’s investment strategy does not seem to appropriately address the risks of inadequate diversification, we shall adopt the following approach:

  1. Where at least 90% of a fund’s investments are in one asset or asset class, our audit will always focus closely on compliance with Regulation 4.09.
  2. Where 80%- 90% of a fund’s investments are in one asset or asset class, in our opinion this is a grey area and our focus on compliance with Regulation 4.09 will be on a case by case basis.
  3. Where less than 80% of a fund’s investments are in one asset or asset class, our audit is unlikely to focus on considering whether there has been a breach of Regulation 4.09 unless specific isolated issues demand our attention.

As noted previously, it is important to understand that the trustee must regularly review and give effect to the strategy.  If the fund is doing something outside the parameters of their strategy, we will report this in our management letter to the trustee.  Furthermore, should the reporting criteria be satisfied, we may lodge an auditor contravention report.

To reiterate our position earlier, where a strategy states “… the risks of inadequate diversification have been considered”, this will negate exposure to a breach of the regulation and therefore satisfactorily meet our audit requirements.

As always, we encourage you to contact us with any queries or comments you may have regarding this or any other audit issue.