Navigating Derivatives and Options in SMSFs

One of the main reasons SMSF trustees invest in risky assets such as derivatives and options is that they think they can outperform the market and get a quick return.

Traditionally, very few trustees make a reasonable return from these types of investments. Unless they are professionals, most post losses (sometimes significant ones) and make only short-term gains.

Because SMSF trustees will keep investing in high-risk assets no matter what, SMSF professionals need to understand derivative investments to ensure fund compliance.

What Are Derivatives and Options?

A derivative investment is a contract that allows an investor to buy or sell a set number of shares or commodities at a specific price on a predetermined date. Although investors trade contracts rather than physical assets, each contract is tied to an underlying asset.

In real terms, the investor does not have to own the assets at any point to make a

profit, regardless of whether stock, commodity, or forex prices rise or fall.

At all times, the taker (the buyer) has the right, but not the obligation, to buy or sell the security. To acquire this right, the taker pays a premium to the writer (seller) of the contract.

Options are usually issued over shares, exchange-traded funds (ETFs), market indices or low exercise price options (LEPOs).

There are two (2) types of options traded on the Australian Stock Exchange (ASX):

1. Call option – gives the taker the right, but not the obligation, to buy the underlying shares

2. Put option - gives the taker the right, but not the obligation, to sell the underlying shares

   
   

While the taker is not obligated to exercise the option, they may sell it before the contract expires or let it lapse and forgo the option premium.

SIS Compliance in Derivative Trading

First, the fund's trust deed must permit investment in derivatives and, second, the investment strategy must consider why the trustees intend to invest in derivatives.

Under r13.14 SISR, SMSF trustees may not give a charge over the fund assets, including a mortgage, lien, or other encumbrance. The regulation prohibits trustees from activities such as participating in margin lending products.

One exception applies when the fund creates a charge over fund assets by investing in derivatives, such as options and futures.

Under r13.15A SIS, an approved charge on fund assets can be given over investments with Australian and specified foreign stock exchanges and futures exchanges ("approved body") as long as:

• the derivatives contract complies with the rules of the approved body (13.15A SIS), and

• the fund has a Derivatives Risk Statement (DRS) in place.

Charge Over Fund Assets

Trustees can give a charge over the fund's assets under certain circumstances, allowing them to trade derivatives through the list of approved bodies in SISR Sch 4, including domestic and foreign exchanges and clearinghouses. 

Most importantly, under r13.15A SIS, a DRS must be in place, separate from the investment strategy, which outlines:

• Policies for using derivatives, including an analysis of the risks associated with using derivatives within the fund's investment strategy

• The restrictions and controls on using derivatives, taking the expertise of the staff involved into consideration

• The compliance processes to ensure the controls are effective

Remember, too, that while the term "derivative" applies to a variety of financial arrangements, not all are eligible obligations that will meet the requirements under the SIS legislation.

The ATO has stated that in general, an SMSF should not use derivatives as a speculative tool in situations where:

1. The fund's net exposure to an asset class is outside the limits set out in the fund's investment strategy.

2. The fund's total portfolio is geared up through derivatives to circumvent the borrowing limitations imposed by SIS s67

Rights Issues and Options

A company can elect to raise capital by offering shareholders a rights issue.

In most cases, shares issued through the capital raised are priced at a discount to the prevailing share price, based on the volume-weighted price leading up to the offer.

In a rights issue, a company may also offer shareholders other entitlements, such as options, that allow it to raise more capital in the future. Options are made available to investors under many varied conditions but have an exercise date and price attached.

Under these circumstances, the trustees did not have to provide a charge over the fund's assets. The options were free, and the trustees could choose whether to exercise them.

If the fund purchases more options in the same company through the ASX, it provides a charge over the fund's assets and a DRS is required.

Employee and Performance Options

Directors, executives, and employees can receive share/option schemes and performance shares, rights, and share options as employment incentives.

Generally, shares or options transferred to an SMSF under an employee share scheme ('"ESS") are considered an acquisition from the employee or director (usually a related party of the fund).

SMSF trustees may acquire shares or options from a related party at market value if either:

• the shares or options are listed on the Australian Securities Exchange (ASX)

• the company is a related party of the SMSF, and the acquisition will not result in the fund's in-house assets exceeding 5%.

An issue arises when listed shares or options are transferred to an SMSF for no consideration or for less than market value. However, if the acquisition is at market value, the difference between the market value and the actual consideration paid is treated as a contribution.

Some companies also provide these arrangements based on a greater return on equity depending on the employee's or director's performance. This could give rise to non-arm's length considerations (NALI) that apply to any dividends or capital gains an SMSF derives from ESS shares. SMSFs are also at risk in these circumstances if the remuneration paid to the employee or director is below market value.

An SMSF generally cannot acquire shares or options from a related party unless an exception under section 66 of the SIS Act applies. The main exception is for listed securities acquired at market value.

🎁Bonus Reading

CFDs can raise complex issues for SMSFs. In my article, Is Trading CFDs in an SMSF Worth the Risk?, I explore the risks and compliance considerations SMSF professionals need to understand before trustees enter these arrangements.

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