Changes to the pension rules from April 2006 have increased investor awareness of self-invested personal pensions, particularly in terms of the investment options available.
Investors are no longer satisfied with selecting from a range of collective funds and are demanding access to more sophisticated types of investment. One option that could be of interest to Sipp investors are contracts for difference.
Trading of CFDs has increased fivefold in as many years and they now account for more than 30 per cent of the daily trading volume on the London Stock Exchange. The main reasons for this include the low deposit required to place a trade and the ability to make profits from falling prices.
What exactly is a CFD? Very simply, it is a contract between two parties to exchange the difference between the opening and closing price of the contract. It enables the trading of shares or markets, with the key difference from ordinary equity trading being that profits can potentially be made from falling markets or share prices as well as rising ones. It is possible to trade almost any market or asset type required, although dealing within Sipps is currently restricted to equity CFD trading only.
The market capitalisation of UK stocks must usually be over £50m although some brokers such as IG Index offer trading of stocks with capitalisation as low as £5m. US and European stocks must usually have capitalisation of over $500m or euro 500m. All major global indices, commodities, futures and currencies are available.
An added benefit when trading UK stocks is that no stamp duty is payable as a CFD is a derivative product.
The main difference between trading a CFD and an ordinary share is that, instead of paying the total price and owning the shares outright, the investor only pays a percentage deposit and effectively borrows the rest. Typically, only between 5 and 10 per cent of the price is paid, plus a financing charge on the outstanding amount on a long position or financing will be received on a short position.
By going long, it is possible to benefit from an upwards price movement by buying shares at a low price and then selling at a high one. This is similar to traditional equity trading. By selling short, an investor is able to benefit from falling prices by selling shares at a high price and then buying them back again at a lower one. Profits (or losses) are made on the difference between the two prices, with a deduction for the broker’s commission.
Some investors also use CFDs as a means of hedging any potential losses on their share portfolio.
It must be remembered that there is an element of risk involved and the use of CFDs in Sipps is not for the faint-hearted. The leverage on deals is a real advantage when profits are made but by the same token it can also increase losses. Therefore, an investor could face unlimited liability if the positions are not monitored carefully.
It is possible to build a stop loss into each trade in the same way as in regular share trading and spread betting. This allows the investor the ability to pre-determine his appetite to risk and exposure on a trade-by-trade basis and avoid the need to monitor each position on a minute-by-minute basis.
In a lot of cases, Sipp funds are limited and there is not the ability to top up funds by means of new contributions. Therefore, when placing deals on behalf of Sipp trustees, most brokers will insist on there being strict controls in place to prevent adverse market movements forcing them to call for more funds to keep a position open.
These controls include placing a limit on each contract size so there are always sufficient funds deposited in the account to cover open positions and automatic stop losses on each deal. The terms of dealing accounts are usually tightly drawn up to limit the liability of Sipp trustees at the hands of inexperienced or unlucky investors.
Overall, are CFDs suitable for Sipp investors? The same question could be asked of a number of the new investments now available in Sipps. The relaxation of investment rules have seen members seeking to invest in a whole range of unlisted shares, offshore funds and smaller equity markets that were not previously available to them.
The usual rule of having many eggs spread across many baskets applies and there is certainly a place for CFDs and other alternative investments as part of a well-balanced portfolio.
CFDs offer the ability to provide returns in excess of those from traditional equity trading. However, it is important to note they are high-risk investments and placing and monitoring them should be left to experts.
Each Sipp provider has its own rules on whether CFDs and other similar investments are permitted in their contract and on how the account should be structured with the broker.
HOW contracts for difference work
An investor may decide that BP looks cheap. It is quoted at 530p/531p so he buys 10,000 shares as a CFD at the offer price of 530p. Instead of paying the full value of the shares (£53,100), he only has to supply a 5 per cent deposit or £2,655.
Three weeks later, BP has risen to 570p/571p and he decides to take his profit. He sells 10,000 shares at the bid price of 570p. The profit on the trade is calculated as follows:
Closing level 570p
Opening level 531p
Profit is calculated as 10,000 x 39p = £3,900. Commission and interest charges would be deducted from the profit