Derivatives and your DIY fund

Certain types of derivatives can protect the value of your share portfolio.

Summary: The ATO has sounded a warning over the growing use of derivatives in self-managed superannuation funds. The total value of derivatives within SMSFs has more than doubled over the past three years. But not all derivatives are the same, and some instruments are more of an opportunity than a problem for investors.
Key take-out: Buying simple derivatives like call and put options can be a legitimate and effective way to manage investment risk. On the other hand, selling certain derivatives can create potential for large and sometimes unlimited losses.
Key beneficiaries: SMSF trustees and superannuation accountholders. Category: Superannuation.

It seems like every few weeks we must have another self-managed super fund “scare” – this time it came from the Australian Tax Office being concerned about the growth in SMSFs using derivatives.

Recent ATO data showed that SMSF use of derivatives has grown from $522 million in 2010 to $1.4 billion currently. Sections of the media quickly hyped this up into a storm of protest from “experts”, decrying all forms of derivatives as akin to WMDs (weapons of mass destruction).

With memories still fresh from the derivative-triggered crash of the GFC, it’s no wonder that controversy surrounds this topic. But the noise hides the benefits and opportunities that simple derivatives strategies can deliver (like protecting the value of your share portfolio). At the same time, it’s crucial to understand how to spot and avoid the risks and compliance pitfalls that derivatives can deliver.

SMSFs – what are derivatives?

Derivatives are financial instruments where their value is linked to (derived from) movements in the value of other assets. It’s worth pointing out that investors are already exposed to derivatives through many mainstream products, including traditional managed funds, long/short funds and, not to mention, hedge funds.

But for most retail investors, when it comes to derivatives there are two main types: “options” and “futures” contracts.

Options give the holder the right to exercise the option (the option holder can choose whether they wish to exercise the contract, or let it lapse). Futures contracts are contracts for the forward sale/purchase of an asset, and unlike an option, the futures contract parties don’t have the right to choose to exercise (or not).

The recent ATO statistics don’t seem to include over the counter or structured products, which contain derivatives. Buying shares or other assets using installments, or limited recourse loans, don’t seem to be included in these stats either. Although limited recourse loans do give the holder the right to choose whether to repay the loan or to “walk away” from it, they are not regulated as “derivatives”.

Why use derivatives?

In Australia, investors can buy derivatives from many sources and can also trade them via the Australian Securities Exchange option market. Buying derivatives is far simpler to understand and risk manage than the far riskier strategies involved in selling them!

Buying a call option means the investor can participate in the upside of the underlying asset, knowing that if the asset price falls the investor has secured two benefits:

  1. The investor’s loss is limited to the amount originally paid to buy the call option;
  2. The investor can elect not to exercise the call option, thereby ending exposure to that position.

For example, an investor can buy an ASX call option over BHP shares maturing on June 26, 2014 with an exercise price of $38 (compared to today’s BHP price of $37.62) for a premium of $2.36. If BHP’s share price rises the investor can profit (assuming the price rise at least covers the cost of the option); while if BHP shares drop in price the investor’s downside is limited to the option cost – i.e. $2.36.

Investors can also buy put options to insure against the risk of capital losses. Buying a put option over BHP shares maturing on June 26, 2014 with an exercise price of $37.50 would cost $2.49 today.

Options are also available over the broad market. For example, protecting against the broad market index (S&P/ASX 200 index) falling by more than (say) 10% currently costs around 4% of the overall portfolio value. In this strategy, dividends received on the underlying share portfolio will cover the cost of the put option.

Even if you don’t hold all the shares that are contained in the S&P/ASX 200 index, a portfolio of large cap/blue chip shares will typically be highly correlated with the performance of that index – meaning this strategy will still be worthwhile.

It’s the leverage as well as limited downside risk that makes buying options a potentially powerful tool for investors.

SIS Act regulation of derivatives

SMSFs are regulated by the Superannuation Industry Supervision Act (“SIS Act”), which in section 52 requires that all superannuation funds prepare and adhere to an “investment strategy” which takes account of the risk involved in “making, holding and realising” any investment.

For many SMSFs, this is often a simple document outlining broad asset classes and giving broad flexibility to invest across them.

When derivatives are used, care needs to be taken to expand the investment strategy and to set out detail regarding:

  • Upfront costs of derivative/s used in the SMSF;
  • Any ongoing liabilities for margin calls;
  • Any further costs or liabilities that may arise at or prior to the maturity date of the derivative.

Over the counter futures contracts, such as contracts for difference, are not a permitted form of investment for SMSFs, and the detailed reasoning for this is set out in ATO ID 2007/57. It states that CFDs are “synthetic” financial instruments not involving an “approved body” in relation to margin calls. That reflects the ban in the SIS Act on a super fund giving a “charge” over its assets, except in very limited circumstances.

On the other hand, buying simple derivatives like call and put options can be a legitimate and effective way to manage investment risk.

Selling derivatives is a different proposition and can create potential for large and sometimes unlimited losses. Working with ASX listed options can be assisted by accessing the detailed educational materials set out on the ASX website

Exotic or OTC options, and even so-called “simple” CFDs, are far more likely to create unforeseen risks, as well as regulatory obstacles that SMSFs should avoid.

Tony Rumble is the founder of the ASX-listed products course LPAC Online, a provider of investment training to financial services professionals. He provides asset consulting and financial product services but does not receive any benefit in relation to the product reviewed. Twitter: @TonyRumble.

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