Inexperience with derivatives will create losses

SMSF derivatives

Inexperienced SMSF trustees seeking new sources of retirement income are likely to lose out by investing in derivatives.

SMSF trustees looking to use derivatives as investments to generate higher than market returns are likely to lose money due to their inexperience with these types of assets, an SMSF educator has warned.

ASF Audits head of education Shelley Banton said due to historically low official interest rates SMSFs looking to generate retirement income may be considering the use of derivatives to replace cash and term deposits “because they think they can outperform the market and get a quick return”.

“Typically, very few SMSFs make a profit from these types of investments, and unless they’re professional stockbrokers, most of them post losses (sometimes significant ones) and take only short-term gains.

“For SMSF trustees to attempt the same type of trading is incredibly dangerous, according to ASIC (Australian Securities and Investments Commission), and likely to lead to massive losses which could not happen at a worse time for many trustees during COVID-19.

Banton pointed to a warning from ASIC in May of this year in which the regulator cautioned the use of derivative investments by retail investors in volatile markets created by COVID-19.

At that time, ASIC stated it had seen an increase in derivatives investment activity by retail investors, including greater exposures to risk, and some investors were unsuccessfully using short term trading strategies to time pricing trends.

This was evident in a large increase in the number of new retail investors as well as the reactivation of dormant trading accounts, as well as the frequency and number of trades each day and shorter durations for the holding of derivative investments, ASIC said.

Banton noted SMSFs appeared to be participating in these trades with the majority of applications for a Legal Entity Identifier (LEI), which is required to trade derivatives on the ASX, coming from SMSFs.

“Since October 2019, ASIC has required SMSF trustees to have a LEI if they are trading non-exchange traded instruments such as CFDs and foreign exchange.

“SMSFs accounted for the majority of growth in LEI applications, which increased by 84 per cent during the September 2020 quarter due to COVID-19.

“Given the current low-interest-rate environment, this further supports the increased risk appetite of SMSF trustees chasing higher returns through derivatives.

Banton added high-risk investments were possible within an SMSF but funds should consider additional warnings from the ATO to not use derivatives investments as a speculative tool.

“SMSF trustees need to understand all the risks and make sure they have the correct documentation in place. In most cases, SMSF trustees will be betting against professionals, and every contract they enter into has a winner and a loser,” she advised.

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