SMSFs and derivatives - a potential diversification option
Investing in derivatives has been one of the popular investment options for savvy investors. As the ATO has been posing the question to some SMSF trustees whether their investments are appropriately diversified, do derivatives provide legitimate diversification opportunities for SMSFs?
In a nutshell, superannuation laws do not prohibit this type of investment, however SMSF trustees should carefully observe the relevant compliance requirements.
Are you investing in derivatives?
Derivatives transactions include a broad assortment of instruments such as options, futures, warrants, swaps or Contracts for Difference (CFDs). A derivative is fundamentally a contract between parties where the value of the contract is ‘derived’ from that of the particular asset(s) the contract is linked to.
In a typical derivatives investment, the investor enters into a contract (which gives rise to certain contractual rights and obligations between the parties) without the investor actually owning the underlying assets that the contract is linked to and derives its value from. The underlying assets can include shares, commodities, currencies and a variety of other asset types.
Note that some Exchange-Traded Funds (ETFs) can also be derivatives. Although many ETFs are not derivatives, some may be considered as such if the assets held in the ETFs are themselves derivatives. If so, the trustee investing in such ETFs should observe the compliance requirements applicable to derivatives investments.
What are the SIS compliance requirements?
Like with any other investment options, investing in derivatives must satisfy the sole purpose test. The fund’s trust deed should also be reviewed to check whether the proposed derivatives investments are permitted by the fund’s trust deed.
The investment strategy of the Fund should also be reviewed to see if the proposed derivatives investment is within its scope. Financial implications of investing in derivatives including the associated risks with such investment should be carefully considered and it would be advisable for trustees to seek appropriate financial advice in this regard. This will also help them discharge their general trustee obligations in relation trust investments (including SMSFs) which obligations are incorporated as overarching covenants in the SIS Act.
Further, if the derivatives give rise to a charge over the assets of the fund, there is an additional requirement to have a formal derivatives risk statement in place. Not all derivatives require the investor to give a charge over its assets as security. If however a SMSF trustee is investing in a derivative which requires the trustee to give a charge over the assets of the fund, the trustee must have in place a formal derivative risk statement and comply with the terms of the statement throughout the investment period.
A derivative risk statement should set out the following:
(a) what policies the trustees will adopt in the use of derivatives;
(b) how the trustees will analyse and assess the risks associated with the use of derivatives;
(c) how the use of derivatives fits in with the investment strategy of the fund;
(d) what restrictions and controls the trustee will put in place to regulate the use of derivatives, particularly taking into account the expertise available to the Fund; and
(e) the compliance processes to ensure the controls are effective.
SMSF auditors are also expected by the ATO to check and ensure that an appropriate statement is in place and that the relevant derivatives investments (and the charge thereby given) are consistent with the terms of the statement.
The issues discussed above are not exhaustive and a trustee considering such investment should obtain appropriate advice to ensure compliance.
Please contact Townsends Business & Corporate Lawyers on (02) 8296 6222 or email firstname.lastname@example.org should you require legal advice in relation to your proposed SMSF investment.