SMSF Technical Education & Strategies

 

Can you invest in or trade derivatives (options & futures) in your SMSF ?

With the growth in both derivative trading and SMSFs over the last decade, the inevitable question has been raised of whether derivatives can be traded inside a Self Managed Super Fund (SMSF), and if so, under what restrictions or parameters?

Are derivatives generally allowed in SMSFs under the SIS act?

To come to a conclusion on the above question, we need to define what derivatives are under the SIS act, and then look to any sections of the act that may restrict their use. Definitions – under the SIS act, derivative means “a financial asset or liability the value of which depends on, or is derived from, other assets, liabilities or indices”. A derivatives contract means “an option contract or futures contract relating to any right, liability or thing”.

 

So basically, we are looking at those instruments commonly known as options and futures. SIS Act – This is the Superannuation Industry Supervision (SIS) Act, the body of superannuation law. The SIS act actually prescribes very few restrictions on exactly what type of investments trustees can go into, however it is quite prescriptive on the way investments can be structured. As far as derivatives are concerned, the main issue is the fact that some derivative contracts have a margin, or collateral requirement, and hence may fall foul of Regulation 13.14. That is, the trustee must not give a charge over, or in relation to, an asset of the fund.

 

However there is an exception when it comes to derivatives. Regulation 13.15A states that a trustee may give a charge over an asset of the fund if:

- the charge is given in relation to a derivatives contract
- the charge is given in order to comply with the rules of an approved body (such as the options clearing house)
- the fund has in place a derivatives risk strategy
- the investment to which the charge relates is made in accordance with the derivatives risk strategy

So it would appear that under the SIS act, derivatives are a legitimate and allowable investment for a SMSF providing the above are satisfied.

 

What is needed to allow derivatives to be used in your SMSF ?

While we have satisfied above that derivatives are allowed in a SMSF as far as the SIS act is concerned, there are still a few things that trustees need to have in place to be fully compliant when using derivatives in their own SMSF. This includes checking the trust deed, and having in place a Derivatives Risk Statement and a Written Investment Strategy which describes the use of derivatives.

 

Trust deed

Your trust deed is basically the governing rules of your fund. For you to do anything in your fund, your trust deed needs to allow it. So the first step is to look under the    “Investments” section of your deed, and see if it allows investment in derivatives. Most deeds should, but never assume. You always need to check.

 

Derivatives Risk Statement

As mentioned above in relation to regulation 13.15A, a Derivatives Risk Statement is required (and must be adhered to) where the trustees are entering into derivatives contracts where collateral (i.e. margin) is held. This applies for all futures contracts and “sell to open” options contracts. This document follows a specific format and requires some specific information to be included. Members of The SMSF Review have access to our sample derivatives risk statement to use as they wish.

 

Written Investment Strategy

This sets out the investment strategy for the fund, and must include how derivatives will be used. Derivatives should not be treated as a separate asset class, but rather as part of the exposure to the asset class to which the derivative relates. Whilst this seems logical, it does raise the issue of how to measure the exposure of a derivative contract. The written investment strategy states the asset class parameters (e.g. Shares 30% to 70%) for a SMSF, and it is taken that the trustees will manage the assets of the fund to conform within these parameters. Therefore when entering a derivative contract, trustees will need to calculate the exposure that the derivative contract adds to the relevant asset class, ensuring it remains within their stated parameters.

 

The question therefore is, how to measure exposure ? With no clear cut directive on this issue from the regulator or in the SIS act, a common method to use is to take the calculation of the exposure to the asset class of a derivative position to be the same as that used for the valuation of the position, as follows:

Bought call or put options to open: Market value of the option contract.
Sold call or put options to open: The current unrealised profit or loss of the open position.
For all futures contracts to open: The current unrealised profit or loss of the open position.

This method ensures the total exposure to all asset classes always adds up to 100% and is consistent with the valuation of the fund as a whole.

 

A point from the ATO

After discussions with the regulator of SMSFs (the ATO), it was made clear that the main issue they have with trustees using derivatives in a SMSF (apart from having all of the above documentation in place) is to be able to show compliance with regulation 4.09 of the SIS act as below:

REGULATION 4.09 OPERATING STANDARD - INVESTMENT STRATEGY
4.09(2) [Considerations in formulating strategy]
The trustee of the entity must formulate and give effect to an investment strategy that has regard to all the circumstances of the entity, including in particular:
(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.

 

One final point. You cannot run a business inside a SMSF, therefore the derivatives trading must not be in the form of a business where typical business deductions are being claimed or wages withdrawn.

 

Summary

Derivatives are a legitimate and allowable investment inside a SMSF, however for full compliance you will need:

· A trust deed that includes derivative contracts as an allowable investment.

· A Derivatives Risk Statement if margin or collateral is required (i.e. futures & ‘sell to open’ options)

· A Written Investment Strategy that includes the use of derivatives. Trustees must also be able to show that it has been formulated with regard to regulation 4.09(2) (above).

· To ensure that when derivative contracts are opened, the exposure is calculated and allocated to the relevant asset class, and is within the funds’ asset class parameters as stated in the investment strategy.