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Self Managed Super Fund (SMSF) Article
SMSFs and CFDs
By Tony Negline.
This article may be out of date.
20th February 2008
Since the mid 1980s the super laws have banned super funds from explicitly borrowing except in limited circumstances.
The prohibition was put in place because whilst investment gearing can accelerate returns it can also supercharge losses.
The rule's current wording was redrafted in the early 1990s when concepts used to effectively control investment risk were beginning to gain widespread financial markets acceptance. The sophistication of these products is such that if used inappropriately they can lead to significant losses. Like all financial market structures these risk minimization tools have continually evolved but the super funds borrowing restriction has largely remained static.
One of the main principles behind the super law borrowing restriction is that it assumes one party in an arrangement is a lender and another party is a borrower. If the borrower defaults on their obligations, lenders are protected because of the security they will hold over a borrower’s assets.
But not all borrowing involves this type of relationship. For example most business credit terms arrangements do not give rise to lender/borrower relationships.
Super funds can use gearing arrangements which do not give rise to formal lending and borrowing arrangements.
Contracts for Difference or CFDs are an example of gearing arrangements which are more in line with debtor and creditor arrangements.
CFDs are contracts which allow a purchaser to make profits or losses from the movement in the price of the CFD. Officially these products are known as Over-the-Counter products, that is, they are not traded on an exchange or market.
A CFD's price is either directly or indirectly based on the current market price of a share, a sharemarket index or a currency. The profit or loss that an investor will make on these contracts will depend on the difference between the CFD's open and close prices, commission paid to the CFD provider, interest costs if the CFD remains open overnight and other administration costs and adjustments. When a CFD’s underlying share pays a dividend most CFD providers will pay a proxy amount for these payments however it would appear, very importantly for super fund investors, that any attached franking credits are lost.
The advantage of CFDs is that you can gain full exposure to movements in a share, market exchange indices or currency movements for very little outlay. For example suppose BHP Billiton is currently $38 per share. To gain full exposure to 500 shares would cost a fund $19,000. A CFD would provide access to the movement in the 500 BHP shares for an initial outlay of about $950 plus costs.
Ignoring costs, if the BHP shares increased by $1, both investors would have earned a $500 profit. The direct share investor has made a 2.6% return whereas the CFD investor has made a 52% profit. If the share price dropped by $1 then a $500 loss is created which means the CFD investor has lost 47% but the direct share investor has lost 2.6%.
A CFD purchaser who wants to make money on the BHP share price increasing will buy a "long" CFD. CFD purchasers can make money on the BHP share price going down will buy a "short" CFD.
To smooth the operation of these products all CFD providers demand that purchasers deposit a "margin" with them. The margin is designed to keep sufficient money in an investors account to ensure an investor has covered some or all of their open CFDs. The level of margin fluctuates as the market price of the share, index or currency changes. The investor has to make sure they keep sufficient margin in their account.
Most CFD providers also demand that superannuation fund investors also put in place stop orders which are designed to minimize losses. In our example above a CFD client might ask the provider to close the position if the BHP share price falls below $36. This would mean that an investor's total exposure is $1,000 ($2 x 500) plus costs. Additional costs will be incurred for implementing a stop order. Some CFD providers also demand that super funds provide higher margin than ordinary investors.
Super funds that wish to use CFDs need to pay very close attention to the wording of the CFD contract as well as the wording of the super rules. The ATO has issued two Interpretative Decisions (2007/56 and 2007/57)) on these products.
The ATO says that super funds can use CFDs if they fit into a super fund's written Investment Strategy. Also the super funds assets must not be subject to any charge, must not have borrowed any money to enter into a CFD and must not have a beneficial interest in the money deposited in a CFD provider's bank account which, under the terms of the contract, are the property of CFD provider.
A super fund trustees will also need to draft a Derivative Risk Statement.
Super funds may be confused because the ATO description of CFDs is different to how most CFD product providers operate their business affairs.CFDs are not for the faint hearted. ASIC's consumer website, Fido (fido.gov.au), says that only those who have extensive experience in financial market trading especially in volatile markets, excellent knowledge on how CFDs work, have "fail safe trading systems set up to stop unacceptable losses" and have the financial capacity to "afford any losses that … [a] trading system cannot avoid" should consider using CFDs.
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