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Self Managed Super Fund (SMSF) Article
SMSFs and Derivatives

By Tony Negline.

This article may be out of date.

7th June 2006

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Many super fund investors are looking for ways to improve the return on their investments.

The super laws allow super funds to invest in derivatives that are offered under rules established by most futures and stock exchanges throughout the world.

Derivatives are financial assets or liabilities whose values are determined by other assets, liabilities or indices.  There are many different types of derivatives.  For example, forwards, futures, options, warrants, swaps, share ratios, etc

A super fund might use derivatives for a variety of purposes.  For example derivatives can spectacularly improve portfolio returns or limit potential losses if a trustee is concerned about the value of the asset falling.

These powerful products will only work successfully if an investor knows what they are doing.  Some very large companies have gone broke when a few rogue employees have misused derivatives or derivative type products.

Despite the risks, an increasing number of super funds are using these types of products because of the potential to earn a better return on a fund's listed shares.

Any super fund that uses derivatives must make sure that their trust deed allows a trustee to use this type of product.  Under the super laws a super fund that uses derivatives must also have a Risk Management Statement (RMS).  These statements must reflect three key issues:

What penalties apply for not complying with the Risk Management Statement requirement?  This obligation is an ‘operating standard’ which are specific principles about fund administration and operation which super funds must meet at all times.  A failure to satisfy these requirements can lead to a range of fines and penalties.  A super fund’s external auditor would be expected to see a fund’s RMS and how it has been implemented and the auditor would be expected to report any breach to the regulator.

So how would a super fund use options?  A super fund could be an option taker or an option writer.  The writer purchases the right to buy or sell a parcel of shares at a predetermined price on before a predetermined date.  To acquire this right the writer pays the taker a premium when the options contract is written.  The option writer does not have to exercise the option.

There are two different types of options – puts and calls.  A put is when the taker has the right but not the obligation to sell shares at a specified price whereas a call option potentially gives the taker the right to buy shares at a specified price.

So how would a super fund use options?  Options can be used to make money or to protect against losses.  And there are hundreds of different ways of using options.

Lets look at a very simple example called a covered call option.  The Smith Family Super Fund has owned Woolworths Limited (WOW) shares since they were refloated in July 1993 and over the past 10 years it has bought more of this stock.  The fund now owns 5,000 Woolworths shares.  The fund has no immediate intention of selling these shares.

The SMSF decides to write covered call options with an $20.00 per share strike price. The options are worth 10 cents each and are exercisable over the next 6 months.  For these options the fund  receives $500 ($5,000 x 10 cents).

The fund knows that if the Woolworths share price exceeds the $20.00 strike price then it may have to sell the shares because the options buyer might want to buy shares for less than the current market price.  Twenty dollars is more than the fund paid for the shares so even if it is forced to sell they will still make a gain.  However this gain per share will be less than if it had merely sold them on the open market.  Nevertheless, the Smith Family Super Fund trustees might be peeved that they are getting less than the prevailing market.

The fund trustees know that if the share price is less than $20.00 it will probably get to keep their shares and will have received the additional income.

The standard number of shares covered by one option contract is 1,000.

The latest Tax Office statistics say that about 32% of all Self Managed Super Fund assets – or  about $53 billion – are invested in listed shares.  Some of these funds might finding using share options worthwhile.  However clearly options are a complex investment product and a SMSF that wanted to use them should make sure they not only understand how to use them properly and also satisfy their legal obligations.

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