Derivative use a concern
23 October 2013
There is growing use of derivatives in SMSFs, which is a dabbling with risk that could lead to significant losses. According to the ATO, derivative use in SMSFs rose from $522 million in March 2010 to $1.4 billion in June 2012. While this is only a small percentage of the $500 billion under management in the SMSF sector, it is a disturbingly fast growth rate.
The ABC points out that over the same period the RBA's official cash rate fell by half. The pursuit of higher returns is no doubt behind the dabbling in higher risk investments. But the problem with derivatives (transactions "derived" from more conventional trades in asset classes) is that it typically involves higher degrees of leverage. And as Noel Whittaker points out in the ABC programme, if you invest $1,000 in a conventional investment the worst you can do is lose your $1,000. But with derivatives you can lose $10,000 or $20,000. The difference is the debt (or leverage).
Derivatives, as Peter Kennedy of Kennedy Investments comments, are used for complex strategic plays. They can be effective hedges, or used to increase yields. But this is extremely complex, and, as Kennedy observes, it requires expertise. He does not advise them for SMSFs "which are normally required to be managed on a conservative basis."
Some of the smartest investors ever seen have lost massive amounts on derivatives. The best example was Long Term Capital Management (LTCM), which had two Nobel Prize winners in economics, including Myron Black who jointly created the Black and Scholes pricing of risk that facilitated the use of derivatives. In 1998, LTCM lost such massive amounts after a punt on the Russian rouble that the then Federal chairman, Alan Greenspan, had to get the world's biggest banks in a room and tell them that if they did not bail out LTCM, then the world finanical system would collapse. Little was learned, and a decade later derivatives nearly destroyed the global fnancial system. The problem is that markets can go a long way in an unexpected direction, and the levels of debt then massively amplify losses.
So SMSF investors should be very wary. Few have the expertise required, and even if they did, there is no guarantee they will not have large losses. Even the documentation can be so complex it carries hidden dangers.
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