1. Background and Context

This Policy is the Derivatives Risk Statement (“DRS”) for NULIS Nominees (Australia) Limited (“the Trustee”). It applies to the Trustee in its capacity as Registrable Superannuation Entity for the MLC Super Fund (“MLCSF”).

The purpose of this DRS is to provide guiding principles and policy directives for the use and oversight of derivatives within the directly managed options (as that term is defined in the Investment Governance Policy) of the MLC Super Fund (together known as “Investment Portfolios”).

This DRS forms part of the Trustee’s Investment Governance Framework. Please refer to the Trustee’s Investment Governance Policy for further information in relation to the Trustee’s Investment Governance Framework.

MLC Super Fund

NULIS has appointed JANA Investment Advisers Pty Limited (“JIA”) to be its investment consultant and MLC Asset Management Services Limited (“MSL”) to be its portfolio manager in relation to the directly managed options in the MLCSF. JIA and MSL are together referred to in this document as “the Advisors”.  JIA provides advice to assist the Trustee to set its investment objectives and investment strategy for each directly managed investment option. MSL implements portfolios designed to meet those investment objectives and in accordance with the investment strategy. JIA also conducts investment manager research to assist MSL in selecting specialist investment managers for the directly managed options within MLCSF. The services are provided in accordance with the Investment Consulting and Portfolio Management Deed (“ICPMD”) between JIA, MSL and the Trustee.  The DRS governs the performance of services and exercise of delegations in connection with investment in derivatives by JIA and MSL under the ICPMD. MSL and JIA have undertaken to comply with the Trustee’s Conflicts Management Policy.

The Trustee of the MLCSF primarily invests in managed investment schemes issued by MLC Investments Limited (“MLCI”) as an efficient means of holding and organising its investments in conjunction with MSL’s portfolio management services. MLCI has appointed MSL as its principal investment adviser. The use of derivatives by MLCI is managed in accordance with MLC Investment’s Derivatives Policy. The Trustee of the MLCSF also invests in some assets directly, including currency overlay assets and fixed income assets and external funds.

In relation to directly managed options, the Trustee as trustee of the MLCSF may have exposure to derivatives either:

• directly – by appointing an investment manager under an Investment Management Agreement, Transition Management Agreement or similar arrangement (“IMA”), and holding assets directly (or via the Trustee’s custodian); or
• indirectly – by investing in collective investment vehicles (including managed investment schemes issued by MLCI) (“Underlying Pools”).

Exposure to derivatives in externally managed options (as that term is used in the Investment Governance Policy) is governed by the Investment Governance Policy.

Definitions

For the purposes of the DRS, a derivative is a financial asset or liability whose value depends on (or is derived from) other assets, liabilities or indices. Derivatives can be either exchange traded or traded over-the-counter and exist in a wide range of instruments including forwards, futures, options, swaps and other composites.

The Trustee will permit the use of derivatives within its Investment Portfolios only where their use is consistent with:

• The investment return objective and risk profile of an Investment Portfolio;
• Disclosures made to investors;
• Governing fund documentation;
• The Trustee’s Investment Governance Policy;
• Superannuation Industry (Supervision) Act 1993;
• Any other legislative or regulatory requirements; and
• The DRS.

2. Purpose of Using Derivatives

Derivatives are an important tool for prudent investment management and are integral to the investment risk management process. Their proper use should enhance the likelihood of meeting the overall investment performance objectives of an Investment Portfolio.

Derivatives may be used in Investment Portfolios for the following purposes:

Hedging:

• Hedging Investment Portfolio exposures (eg to protect the value of an asset in the portfolio and/or minimise the liability from a fluctuation in market values).

Efficient Portfolio Management:

• Creating exposures to markets, currencies, securities and other financial or economic interests within an Investment Portfolio;
• Implementing changes in positions or in investment strategy including shifts in asset allocation between asset classes and/or adjustment to other asset exposures; and
• Reducing the transaction costs associated with the management of Investment Portfolios.

Investment Return Generation:

• Creating portfolio leverage (either long or short) where leverage is permitted as outlined in the investment objectives and risk profile of Investment Portfolios;
• Seeking to enhance Investment Portfolio returns including, but not limited to, by exploiting pricing anomalies between derivatives and the equivalent physical securities and efficiently executing directional views in markets, currencies and securities.

The use of derivatives within an Investment Portfolio must be consistent with the Investment Portfolio's approved objectives and risk profile, disclosure documents, applicable governing documents and legislative and / or regulatory requirements.

The Trustee will not use derivatives for investment activities which results in one or more of the following:

• The net exposure of the portfolio to an asset class being outside the limits set out in the portfolio investment guidelines;
• The portfolio holding uncovered derivatives outside any limits specified in the portfolio investment guideline; and
• The portfolios being ‘geared’ through derivatives in breach of regulations or the portfolio’s investment strategy and guidelines. 

3. Roles and Responsibilities

Roles and responsibilities for the management of the DRS are aligned with the Insignia Financial Group’s Risk Accountability Model and are summarised in the following table:

4. Key Controls

Investment Selection

The Trustee’s Advisors must undertake an assessment to determine which specific types of derivatives should be permitted, consistent with the overall investment objectives, strategy and risk profile of an Investment Portfolio.  This assessment must include consideration of:

• the markets in which the Investment Portfolios will be investing;
• the investment style(s) to be employed;
• the experience, qualifications and skills of specialist investment managers appointed to use derivatives and the experience, qualifications and skills of MSL to monitor the investment managers’ use of derivatives;
• the quality of internal controls/risk management procedures relevant to the use of derivatives; and
• the characteristics of the derivative market involved – liquidity, quality of counterparty, availability of valuations (including equitable valuation considerations), legal structure, and investment limits.

Non-Centrally Cleared Derivatives

Where NCCD transactions are entered into by specialist investment managers on behalf of the Trustee, the specialist investment managers must (as required by Consolidated Prudential Standard CPS226):

• ensure appropriate margining practices are in place in relation to NCCD transactions;
• apply risk mitigation practices including in the areas of trading relationship documentation, trade confirmation, portfolio reconciliation, portfolio compression, valuation processes and dispute resolution processes; and
• take into consideration the nature of the risks and transaction type, as well as size, complexity, and operating environment of the parties to the transactions.

MSL must ensure that where appropriate, all relevant IMAs incorporate relevant provisions to ensure the specialist investment managers comply with the above and MSL will monitor such compliance. MSL will notify the Office of the Trustee of disputes which meet thresholds agreed with the Trustee from time to time. The Trustee must notify APRA of NCCD related disputes that are material either in dollar value or period of time outstanding. 

Mandate restrictions

In the case of specialist investment managers governed by an IMA, MSL must ensure that all IMAs comply with this DRS including appropriate limits, restrictions on counterparties and other provisions to address the controls outlined in Section 5 Risk Analysis.

MSL must ensure that the limits on the use of derivatives contained within an IMA are approved by the MSL Investment Committee, including approval by the Head of Investment Risk.

Investment Portfolio and Mandate Monitoring

MSL must undertake comprehensive investment risk monitoring of Investment Portfolios as a whole to ensure that risk remains within prudent limits that are consistent with overall Trustee approved investment objectives, strategy and risk profile of an Investment Portfolio. Risk reporting must be provided to the Trustee or its Investment Committee.

MSL must ensure that compliance with IMAs is monitored by a team independent of the investment management team, investigate any breach or irregularity and report any significant breach to the Trustee or its Investment Committee.

Underlying Pools

In the case of Underlying Pools, the Trustee’s Advisors must:

• undertake adequate initial due diligence including reviewing the use and control of derivatives and an assessment of the investment manager’s risk management practices and controls;
• undertake periodic reviews to ensure the Underlying Pool’s use of derivatives is consistent with the Underlying Pool’s investment objectives and risk profile and consistent with reasonable expectations of a prudent investment manager.

5. Risk Analysis

The key risks associated with the use of derivatives and the relevant controls in place to identify and manage those risks are outlined below.

Market Risk

Market risk represents the risk of adverse movements in markets (including asset prices, volatility, currency, or other market variables) for the derivatives or the underlying asset, reference rate or index to which the derivative relates. Market risk is created by holding any physical or derivative security which creates exposure to movements in prices of a market, currency, security or other financial or economic interest.

Market risk must be managed through ensuring Investment Portfolios are well diversified across specialist investment managers, asset classes, regions, sectors and underlying securities, as appropriate.

Controls

The following controls must be in place in the case of specialist investment managers governed by an IMA:

• Stress tests must be conducted by MSL to determine the impact of a range of market circumstances on the value of the Investment Portfolios including derivative positions to assist in determining appropriate limits to be set in investment guidelines;
• MSL must set appropriate limits on effective market exposure on both a gross and net basis in investment guidelines, determined in accordance with each Investment Portfolio’s overall risk profile and investment objective including target level of expected returns;
• Appropriate cover requirements must be established to ensure that adequate cash or readily realisable assets are maintained to meet the potential obligations arising from derivative positions;
• Compliance with the investment guidelines must be monitored by MSL on a regular basis.

Liquidity Risk

Liquidity risk has two components:

• Market Liquidity Risk: the risk that a particular position may not be able to be, or cannot be easily, unwound or offset at or near the previous market price because of inadequate market depth or because of disruptions in the market place.
• Cash Flow Risk: the risk that the future financial obligations of an Investment Portfolio will not be met as a result of its use of derivatives, for example margin calls on futures contracts.

Controls

The following controls must be in place in the case of specialist investment managers governed by an IMA:

• Stress tests must be conducted by MSL to determine the impact of a range of market circumstances on the liquidity of the Investment Portfolios including derivative positions to assist in determining appropriate limits to be set in investment guidelines;
• MSL must set specific liquidity restrictions within investment guidelines, recognising the expected level of derivative use, the nature of the underlying exposure, the expected volatility of the derivative contracts being used, and the entire exposure across an Investment Portfolio, including:
  • the purpose for which derivatives may be used;
  • the types of derivatives which may be used; and
  • the limits of derivatives use, individually (Gross Long / Short) and in aggregate (Net).
• MSL must ensure that Investment Portfolios maintain adequate liquidity to cover margin requirements from derivative use, without compromising the Trustee’s requirements to maintain liquidity for other purposes including meeting redemptions; and
• Compliance with the investment guidelines must be monitored by MSL on a regular basis.

Counterparty Risk

Counterparty risk (also known as credit risk) is the risk that a counterparty, being the other party with whom a derivative contract is made, will fail to perform contractual obligations (ie default, either in whole or part).

Controls

The following controls must be in place in the case of specialist investment managers governed by an IMA and MSL must ensure that:

• Counterparty risk is managed in accordance with the MSL Over-the-Counter (“OTC”) Counterparty Risk Management Policy;
• the MSL Investment Committee maintains a list of Approved OTC Counterparties;
• IMAs require that all OTC derivatives be executed with Approved OTC Counterparties;
• IMAs require that all OTC derivatives must be executed under industry standard agreements such as ISDAs (or equivalent);
• IMAs require that all futures and exchange traded derivatives must be cleared through approved clearing entities. These entities be an approved body within the meaning of Superannuation Industry Supervision Regulation 13.15;
• IMAs require that futures must be traded on an approved exchange and must be fully collateralised daily in accordance with exchange requirements. These entities be an approved body within the meaning of Superannuation Industry Supervision Regulation 13.15;
• where counterparty exposure limits are stipulated by investment guidelines or hedging strategies, these are monitored by MSL; and
• the use of Approved OTC Counterparties by specialist investment managers is monitored by MSL.

Operational Risk

Operational risk is the risk that deficiencies in the effectiveness and accuracy of information systems or internal controls will result in a material loss. Such material loss may be caused by human error, system failures, inadequate procedures, or a lack of internal management controls.

Controls

• MSL must ensure that its organisational and reporting structures provide separation of functions between the investment management team and mandate monitoring teams;
• As part of the specialist investment manager selection and ongoing monitoring process relating to IMAs, the Trustee’s Advisors must assess each specialist investment manager’s operational risk, including in respect of derivative use.
• MSL must ensure that applicable controls are outlined and audited in each specialist investment manager’s internal controls report (ie SSAE16, GS007 or equivalent) and ensure that the report is provided to MSL on an annual basis.
• MSL must ensure that all exchange-traded transactions must be settled by the Trustee’s appointed Custodian or Clearers.
• MSL must ensure that the value of all assets, including OTC and exchange-traded derivatives is where practicable marked to market daily using independent valuation sources.

6. DRS Administration

Personnel Management

The Trustee’s Advisors must ensure that all staff responsible for reviewing specialist investment managers, managing Investment Portfolios and hedging portfolios are appropriately qualified and experienced. Staff must be supervised as appropriate to their areas of responsibility and their performance must be reviewed periodically.

All MSL senior management and employees involved in monitoring derivative exposures must have appropriate training and must have an understanding of derivatives and all aspects of the DRS. All representatives must be encouraged to undertake additional training in the interests of maintaining a satisfactory level of professional expertise in regards to derivatives usage.

Assessment of Controls

MLC Wealth Internal Audit periodically assesses the Advisors’ internal control environments and procedures. The Advisers must ensure that procedures are in place to monitor the results of these audits, and must ensure that, where relevant, recommendations are implemented on a timely basis.

The Trustee may carry out audits of MSL’s controls in accordance with the ICPMD.

Reporting

The Trustee’s Advisors must provide such reports as are considered necessary by the Trustee to enable the Trustee to fulfil its responsibilities. Such reporting must include significant investment and policy breaches.  

Review of the DRS

Any change to the DRS requires the approval of the Trustee Board or delegated Investment Committee. The DRS is to be reviewed on a triennial cycle or earlier when required.

DRS Variations and Exemptions

The DRS is approved by the Board of the Trustee or delegated Committee. Material amendments or exemptions from the DRS must be approved by the Board or delegated Committee.

Non-material amendments or exemptions can be approved by the Chief Operating Officer, Office of the Trustee.

DRS Breaches

All breaches of the requirements of the DRS must be recorded, reported, escalated and appropriate remedial action taken in accordance with the Insignia Financial Ltd Group Event Management Standard.

7. Related Documents

The DRS should be read in conjunction with the following Policies, Standards, and Guides as appropriate:

• The Trustee’s Risk Appetite Statement
• The Trustee’s Risk Management Strategy
• The Trustee’s Asset Valuation and Unit Pricing Policy
• Superannuation Prudential Standard SPS 220 Risk Management
• Superannuation Prudential Practice Guide SPG 200 Risk Management
• Superannuation Prudential Standard SPS 530 Investment Governance
• Superannuation Prudential Guide SPG 530 Investment Governance
• Superannuation Prudential Guide SPG 531 Valuation
• Consolidated Prudential Standard CPS226 Margining and risk mitigation for non-centrally cleared derivatives