Of all the funds we’ve audited, very few trustees have made a reasonable return from these types of investments. Unless they’re professional stockbrokers, most of them post losses (sometimes significant ones) and make only short-term investments. And anecdotal evidence from other SMSF auditors matches this scenario.

Trustees will keep investing in high-risk assets no matter what they’re told, so here are a few tips that could make all the difference at audit time.

One of the basic rules (SISR 13.14) about having an SMSF is the trustees may not give a charge over the fund assets. This includes a mortgage, lien or other encumbrance. The regulation prohibits trustees from activities such as:

• participating in margin lending products, and

• creating a mortgage over a property.

One of the exceptions to this prohibition is a limited recourse loan borrowing arrangement, which has its own set of restrictive rules laid out in s67A and s67B of SIS. Another exception is the creation of a charge over fund assets as a result of investment in derivatives, such as options and futures, and Contracts for Difference (CFDs).

An approved charge on fund assets can be provided for 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 (SISR 13.15A), and

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

Documentation matters

The trustee must develop a DRS separate from the investment strategy that outlines:

1. Policies for using derivatives, including an analysis of the risks associated with using derivatives within the fund’s investment strategy

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

3. The compliance processes to ensure the controls are effective.

Many SMSF advisers can help trustees prepare a DRS. Unfortunately, SMSF Auditors aren’t allowed to supply trustees with a DRS template or recommend a specific service provider. Even if they were licensed to give financial advice (which they’re not), it would be seen as a conflict of interest and provide grounds to decline the audit.

In some cases, trustees have been unaware that they have given a charge over the assets of the fund in order to trade derivatives. A simple review of the original documentation signed by the trustees (e.g. the Product Disclosure Statement) will show a charge or guarantee has been provided.

Some of the more 'traditional' derivatives contracts have been traded on various stock exchanges for a long time. The rules and risks surrounding these investments are fairly straight forward. CFDs on the other hand are much trickier and riskier.

Unfortunately, many investors get lured into trading CFDs, trying to tap into a potentially lucrative market, without fully understanding all the risks involved. This is not because investors are “slow” but because CFDs are very complex.

ASIC has said a CFD can make potentially unlimited losses, and has since published a guide to help trustees assess the risks of CFDs.

Depending on the requirements of the CFD provider, a CFD investment will either:

• be allowable under SIS, or

• result in a breach.

When a CFD is opened, the trustee pays a deposit into a CFD bank account. They may also need to make additional margin payments to cover running losses on open positions.

According to the Australian Taxation Office, this doesn’t constitute a loan between the CFD provider and the fund. Needing to pay a deposit and meet margin calls does not represent borrowing. They are contractual liabilities to make payments if and when required—not repayments.

The obligations relating to CFDs are distinguished from margin lending by a broker's margin account relating to shares purchased by an SMSF—a prohibited borrowing under the SIS Act.

It’s a breach if the trustee, under a separate written agreement with the CFD provider, deposits fund assets with the provider as security relating to the trustee's obligations to pay margins. The terms of the agreement state the circumstances in which the fund's assets would be realised, and show intent to create a charge over the assets. By entering into the agreement with the CFD provider, the trustee has contravened regulation 13.14 of the SISR.

High-risk investments are possible within an SMSF. But you need to understand the risks, and make sure the correct documentation is in place.

Unless you’re a professional, however, it will be difficult to make reasonable returns. In most cases you’ll be betting against professionals, and every contract you enter into has a winner and a loser.

Shelley Banton is a director at Super Auditors.