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What to consider when investing in derivatives


The role derivatives can play in a portfolio and the risks that should be considered when investing in them.


 

Derivatives – which include financial instruments such as options and futures – are high-risk trading tools. While institutional investors often use them in a portfolio as a risk management device, self-managed super fund (SMSF) investors should treat them with caution.

Managed funds and derivatives

As Peter Hogan, the Self-Managed Super Fund Association’s head of technical, explains, one way SMSF investors could gain access to derivatives is by investing in a managed fund in which the investment manager uses derivatives as part of their risk management of the portfolio.

“These are large portfolios and using derivatives makes sense. Fund managers have a high degree of expertise trading derivatives, taking positions and understanding exactly what they're doing,” he says.

Hogan notes fund managers use derivatives as a way of managing risk. But as highly speculative instruments, SMSFs should treat them with caution unless they are well versed in the way they work.

“These are highly specialised markets. If you do not have the expertise, and you want that exposure, get it through someone who knows what they are doing, or leave it alone,” he says.

Risk management; tools and instruments

Having said that, Hogan says if an SMSF investor does have the skills to trade derivatives, the idea is to limit the fund’s exposure to manage risk. For instance, SMSFs must make full use of tools such as stop losses to minimise any downside risks attached to trading derivatives.

Stop losses automatically close out a trader’s position to help avoid losing money. It’s possible to open demo accounts to practice trading derivative instruments, before exposing any of the fund’s real resources to these instruments.

Damian Liddell, a financial adviser with Browell’s Financial Solutions, also acknowledges derivatives are incredibly powerful tools that can be used in a number of ways.

“They can be used by accumulators as a speculative tool. Retirees can also use them as a risk management tool. But they can cost a fund a lot of money if they are misused,” he adds.

As such it’s important any exposure to derivatives is not greater than the value of the fund. Any exposure to derivatives also needs to be clearly articulated in the SMSF’s investment strategy. The investment strategy must also deal with how you intend to trade derivatives, the fund’s exposure and limits.

Contracts-for-difference (CFDs) are one of the easiest ways SMSFs can achieve a derivative-like exposure. CFDs are financial instruments that give you an exposure to an underlying investment – for instance currencies and share markets. But they are high-risk instruments that involve leverage. That is, any gains and also any losses are amplified.

But, trading derivatives is a specialised area and few financial advisers would even be prepared to give advice about CFDs. “It would tend to be self-managed super funds with large account balances as well that would be entering into these types of investments,” Hogan says.

Instruments such as instalment warrants can also offer a way for investors to manage risk. Structured instruments that protect an investor’s capital are another way to manage risk. However, they also come at a cost and it’s important to work out whether the cost of protection is worth the potential return over time.

While derivatives can be a source of return and risk management, standard risk management strategies, such as regularly reviewing investment strategies, monitoring the returns the fund generates, proper diversification and asset allocation are also essential. These boxes must be ticked before any derivative strategy is exercised.

In fact, Greg Einfeld, director, Lime Super, notes derivatives are too complex and are unsuitable for most SMSFs.

“SMSFs that invest in derivatives should have a derivative risk statement in place. The trustees should also ensure that the trust deed and investment strategy allow investments in derivatives,” he says.

Any SMSF investor who does wish to pursue a derivative strategy must fully understand the risks to which the fund is exposed and have strategies in place to minimise any downside risk. Investors who do have the skills and confidence to trade derivatives can use them to boost returns and minimise volatility.

But only the most skilled investors should pursue this strategy, always keeping in mind the fund’s sole purpose is to provide retirement savings for its members.

Funds related to this article: Dynamic Markets Fund

Navigating the ups and downs of the market cycle. This fund uses dynamic asset allocation to actively adjust the split of investments across asset classes to achieve diversification in response to market changes.

The Fund aims to achieve growth above inflation1 and smooth out the economic cycle over a rolling 5 year basis.

1Consumer Price Index (CPI) - the Reserve Bank of Australia inflation rate, trimmed mean

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