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 MARKET REPORTS |
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Resident trader
The Trader's SMSF
Will Kraa, January 30, 2007
At a meeting of the Brisbane Sunday Traders some years ago the convener invited someone from the ATO to speak about trading and tax matters. One remark made by the guest speaker really sparked my interest. He stated that as traders we might not be qualified to run our own Self Managed Super Funds. I did not have opportunity to ask him more about what he had in mind but this remark has intrigued me ever since. As far as I can figure it out the only thing he could have meant would be that as a trader you might be tempted to carry on your trading business within your SMSF.
Of course one of the main rules of a SMSF is the rule that the sole purpose of such a fund should be the accumulation of funds for retirement. At first glance this might seem to imply that a good trader should be very well qualified to trade the stock market and make money for retirement. However, the sole purpose test means that you cannot conduct your business within your SMSF. If for instance you are an electrician you cannot use the funds within your SMSF to run your electrical contractor’s business. In the same way, if you are a trader you cannot use the money in your fund to run your trading business.
The one thing that you never want to happen with your SMSF is for the ATO to declare that it is not complying with the rules as the consequences would be financially devastating. So if you are a trader of shares or CFDs and run your SMSF then you have to be very careful about avoiding any suggestion that you are using the money in your fund to trade.
I have therefore been very careful to make a very clear distinction between what I do as a trader and what I do within my SMSF. In my fund I invest in shares but do not trade them. It is of course also necessary to ensure that a prudent policy of diversification is followed and this would usually mean that property is part of the investments in the fund. This is where I have a real conflict with the knuckleheaded approach of the government to ‘in specie’ contributions to your SMSF so please excuse me while I diverge into that topic.
You are able to transfer shares to your fund as an in specie contribution but not property. So if you own cash or shares this can be put into the super fund but if you own investment property and want to contribute it to your fund you must sell it and then put the money into the fund. Then, if desired, the fund can buy more property with the money, so long as it is not the property you used to own. As you no doubt realise, it is very expensive and time consuming to sell and buy property but not at all expensive or hard to sell and buy back shares so this policy is ridiculous. One excuse is that it is hard to value property so that it is hard to work out how much is contributed (for tax purposes). There are all sorts of other instances where property value has to be obtained and this seems to be quite feasible so I don’t think this is a real problem.
Before the last election I wrote to the Labor party to see what their approach to this subject might be and got such a dumb response from Senator Sherry’s office that I gave up on trying to get any sense from that quarter. In this response to my question one of the main objections to allowing the ‘in specie’ contribution of property was that putting property into the fund would in many cases lead to an imbalance of investments and thereby prevent proper diversification that a prudent person might use.
Of course this means that the average SMSF can’t afford to own property since borrowing within the fund is not allowed and in any case property is so expensive these days that the average fund would be hopelessly over-invested in property if it did try to buy into this market. If on the other had in specie contributions of property were allowed then contributed property added to investments already in the fund would be more likely to achieve a balanced approach.
I am sure that the result of this policy means that the average SMSF is heavily overweight shares and cash. It would seem to me that for the average investor being overweight in property might not be such a bad thing anyway. In my case I do own property and would have dearly liked to transfer it to my SMSF especially while there was a window of opportunity to make a large contribution before the recent changes took effect.
But there was no way I wanted to sell the property I have. Not only would it be a ridiculous waste of money but also it would be very hard to replace the property with other of similar potential. Then there is my responsibility to the tenants. It is quite likely that they would have been out on the street to make way for new owners and some of them would have found it near impossible to find and afford other accommodation. (I don’t charge full commercial rates of rent to those who cannot afford it).
My SMSF could afford to buy property but I already have all the property I want to own outside the fund. Therefore there is no way I want to buy more property so my fund will remain invested in cash and shares.
Now I can get back to the real issue of this article – if you should not trade in the SMSF then how do you protect yourself from the sort of volatility evident in the recent market? Of course there are those devoted to fundamental analysis who will say that the way to invest is to find undervalued shares and buy them, possibly by the dollar cost averaging method of buying small parcels at regular intervals hoping the price will average out at some reasonable level. There are other methods of finding shares with desirable fundamental characteristics or you could use the BHP method of investing. No, this has nothing to do with our large mining company but is the acronym for the ‘Buy, Hope, and Pray’ method so popular with many investors.
Most of these methods encourage holding shares no matter what the market is doing.
I think it is possible to do better than this sort of thing. Watching the value of your portfolio rapidly disappearing while the market takes a hammering is not something we need to do. There is no way of knowing how far the market will fall and how long it will take to get back to breakeven so just hanging on and hoping for the best is not advisable. Some companies that look to have good fundamentals and are recommended by analysts turn out to be disasters and even a balanced bunch of blue chip shares can take years or even decades to recover from a market downturn.
What I have found (as have many other experienced people) is that there is always a warning that things are about to take a turn for the worse. There are signs that can alert traders and investors alike that something is about to happen and appropriate action can be taken to minimize the damage to the share portfolio.
Have a look at the chart of the All Ordinaries Index (XAO). The S&P ASX 200 (XJO) is very similar but does not have as much historical data to look back on. The time is the end of July and early August last year. You may possibly remember that period.
The indicators used on this chart are the 3.5ATR(10) in blue, the 150 Day (or 30 Week) MA in red and the 150 Day WMA in dark green (‘dark’ so I can tell it apart from the red one). The WMA (Weighted Moving Average) gives more weight in its calculation to recent prices than the simple MA which is why it is a little closer to the price action. It will give an earlier signal than the simple MA. The Average True Range indicator has a mutiplier of 3.5 to give the market plenty of room to move so that there will be less false signals and it is advisable to react only when the prices fall below the indicator for two successive days. This version of the indicator is the one designed for AmiBroker by Geoff Mulhall (see my article on how to install this indicator in AmiBroker)
The ATR indicator is designed to ‘flip’ to become a stop for a short trade once the price has fallen through it and so I have extended the level at which the price went through the indicator with a red line where necessary.
The first occasion when the price fell below the ATR line is at the first arrow and seeing the next day was a close above the line as extended in red I have labeled it a ‘False Alarm’. This was followed by a rally, another drop where the price touched the line and then another rally as the price broke above the short stop line (as extended in red). Notice that it failed to close above the short stop for two days in succession and so I have labeled it a ‘Failed Break of Short Stop’. This in itself is a warning that the rally was not sucessful and soon after this the price dropped below the long stop line again and this time it was for real.
It also dropped below the 150D WMA and gave a clear warning that a fall was likely. The date was 30 July and we all know what followed in August.
How can this be used for the SMSF where trading is not recommended? For investors there is nothing wrong with being active in managing your investments. There is no rule that says you must hang on to your investments no matter what. So there are several things that can be done. You could sell everything. That is simple and effective and it would have been possible to use the Jim Berg system for individual shares to time entries back into the market once things started to recover.
Another strategy would be to move stops closer. When investing actively I use the weekly 2ATR(10) to monitor prices of investments on a long term basis and as they fall below that it is a sell signal to protect the investment.
This stop is a fair way from the price action and if too many stocks move towards this weekly stop the drawdown fo funds can be dramatic. Also selling once the market has gone into freefall leads to large losses.
Once there is a market warning signal such as this one it would be wise to move stops to the daily 2ATR(10) and sell those stocks which are below that. Any investments that do not fall below this closer stop are doing better than the general market and possibly may be safe to keep unless they do eventually fall below the stop.
For those who have opened an account for their SMSF where you can trade more than just shares, it may be possible to hedge the investments in the fund by short selling CFDs of the same stocks and to the same value as stocks held. This strategy has been mentioned in a ruling by the tax office as being suitable. Or it may be possible to short CFDs over the XJO or sell futures contracts over the XJO of sufficient value to cover the investment portfolio.
Once the market starts to recover these hedging positions may be closed. The profit of the hedging positions should cover the loss in the investment portfolio for a more or less neutral outcome.
Make sure that any such protecting strategies are officially written into your investment strategy for your SMSF and properly recorded.
Now let’s have a look at the way this warning system performed in the latest market disaster to save you from heartache and loss of retirement funds in your SMSF. The chart below is up to date on Tuesday 29 January.
Notice that it is very similar to the chart before in the way signals are given. The indicators are the same. The first warning signal there is two consecutive closes below the indicator stop line as extended (lower red line). This first warning signal was followed by a very brief rally and another very definite warning again.
This was followed by a brief rally which actually broke through the short stop line but failed again to follow through and turned out to be another failed signal to the upside. A failed signal can be a good indicator that the opposite action is likely and so it was in this case. The final warning came as the candle fell though the stop line and both MAs. Again this was followed by another brief rally during the light trading around Christmas (Santa Claus rally?) before disaster struck.
In any case these rallies gave plenty of opportunity to do something to protect investments in the SMSF. I was mostly in cash by the time of the first warning so damage was limited but I will do even more to protect myself next time. I do not have a CFD account in my SMSF as my advisor is not a this stage in favour of the idea so strategies in my fund are limited to selling at this stage. Investments I have left have recovered well so far.
It should also be noted that the long term MA and WMA are both declining. The market therefore is trading below a declining 30 Week MA so buying is not the favourite strategy just now. Any buying encouraged by the appearance of “bargains” should be done with extreme caution if at all as there is no telling where this will end. The market is now in a downtrend and how long this will last is not known.
For trading I can assure you that I have no long postions in any of my CFD accounts at the moment. Any trades I do are very short term to collect quick profits. If suitable pairs can be found then pairs trading (short one stock, long the other) may be appropriate as it lessens market risk. In any case it pays to be patient. Do not be in a hurry to recover any losses as it may lead to further losses. Believe me, I speak from experience and being in a hurry to get even with the market is too risky.
As you can see there are ways to protect your SMSF from the ravages of severe market downturns. These warning come well before real trouble arrives and allow selling at reasonable prices. If your charts extend that far, have a look at the chart of the XAO just before 11 September 2001. If you had used the same warning signals as outlined above you would have been out of the market before this terrible event. Amazing isn’t it?
More articles from this edition of CompareShares:
Trader profile: Trading for a living – Shean Gannon
Takeovers: Should you buy the bidder or the takeover target?
Resident Trader: The Trader's SMSF
Stocks: Stock of the week – Incitec
Commodities: Gold price spike a boon for gold producers
Smart Investing: Market shocks highlight the importance of planning
Expert Panel: Why would I buy an option over a stock I like rather than a share?
Rates: Why the RBA will not hike
Rogue Trader: France says SocGen is "in crisis"
Whatever your views, you can discuss this article - or any of Will's articles - on our message board Your 2 Cents.
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