Australia, Funds Management, Personal Finance - Written by on Sunday, September 14, 2008 21:39 - 0 Comments

How to gear when you think it’s the bottom

Australian Financial Review, September 2008

Back in early 2003, when investors were bruised from more than a year of losses and the second Gulf War was about to kick off, you would have had a hard time convincing anyone it was a good time to gear into the market with a margin loan. But it turns out that the people who did so would have made a killing, enjoying not only a 130% bull run in the next few years but the magnifying benefits of leverage too. Just as the bottom of the market is the best time to buy, it is also the best time to gear.

Deciding whether or not this is the bottom of the market is a whole separate argument, and beyond the scope of this article, although more and more analysts and strategists are saying they think Aussie shares are oversold and will reward investors in the long run. (It must be remembered, though, that gearing magnifies losses as well as gains.) On top of that, following the Federal Reserve’s rate cut, it’s getting cheaper to borrow too. “I think it’s a good time for two reasons,” says Paul Moran of Paul Moran Financial Planning. “One, the cost of borrowing is starting to come down, and every time that happens my expected return can afford to be lower,” he says. “At the end of the day, my expected investment return after fees must be higher than the cost of borrowing to give me benefit.

“Two, in my opinion the Aussie market has fallen by more than it really should have. The unknown is how long it will take the market to revalue correctly.”

But for those who do want to return to gearing, how should they do it and what should they bear in mind? In this article we run through five different methods of gearing and outline the pros and cons.

  • Margin loan.

A margin loan is a simple instrument: you borrow money from a broker to invest in shares. They’re straightforward and generally allow you to invest in a wide range of securities. “They give a client flexibility, such as the ability to change what’s in their portfolio and move in and out of it quite quickly,” says Craig Keary, head of sales and distribution at Westpac Institutional Bank. A margin loan can be invested in a single stock or purchase a diversified portfolio – planners tend to recommend the latter approach – and are transparent. They can be arranged quickly; it’s common to be able to start buying within 48 hours of applying.

Interest rates tend to be about 1% more than a home mortgage rate. Infochoice shows variable rate products for balances below $50,000 tend to be from 10.2% (BT Margin Lending Online) to 10.7% (Macquarie Margin Loan, St George Margin Lending). You need to be confident of beating that interest rate with your returns before a margin loan makes any sense; partly for this reason high-yielding stocks tend to be popular in margin loans, since the dividend pays a good chunk of the interest cost.

The important thing to remember about a margin loan is the possibility of a margin call. Depending on the degree to which you have leveraged, if the value of the stocks you hold falls below a certain amount, you will have to commit more funds to your broker, or sell some of the stocks – at what would very likely be the worst possible time (since the stocks will have fallen in value). Consequently many planners, and also some margin lenders themselves, recommend putting a lid on gearing at 50%, although many margin loans allow much higher levels of gearing.

Margin loans bring a tax advantage in that the cost of the interest is deductible, and can in some circumstance be pre-paid. Most margin loans can be used to invest in managed funds too.

  • Home equity

This involves using your house as collateral against a loan to buy shares. In theory you can do this just through a regular redraw account, but planners tend to recommend using a separate line of credit because it is very important for tax reasons that you can separate the interest costs related to the share purchases from the rest of your mortgage.

Advantages of this approach are that you can stay in the market for a long period of time even if share prices fall, because there is no margin call to worry about. On the downside, they take a lot longer to set up than margin loans – six weeks is not uncommon – and you can’t capitalise interest for tax purposes in the way you can with a margin loan.

“We prefer this for a few reasons,” says Darren Johns, a certified financial planner at Align Financial. “One, the cost of borrowing is usually less.” According to Infochoice, the cost of home equity/line of credit products varies from 8.59% (RAMS, Newcastle Permanent Building Society) to a little over 10%. “Also, there is usually an established facility or relationship, some kind of registered mortgage or loan, which gives the lender a level of comfort with the client. And usually, they’re insulated from margin calls so don’t bring about a forced sale at pretty much the worst time.”

  • Protected equity

In theory, this should be the perfect environment for a protected equity loan. You get the benefits of leverage for when things go up, but if you’re wrong about the timing and the markets continue to fall, then you’re protected.

The reason planners tend to be a bit stand-offish about these products is the very high cost involved. Rates vary according to both the term of the loan, and the stock you invest in using that loan, but here are some examples sourced from Infochoice. For CommSec’s Protected Loan, for one year, the interest rate is a minimum 16.14% and a maximum 31.09%; borrowing for five years would bring those rates down to 11.94% and 21.41% respectively. Maximum rates go as high as 49.01% for St George (for one year, where the minimum is 19.51%); taking Telstra as an example, if you got a three year protected equity loan to invest in it, the lowest you would pay is 14.1% per year (Smith Barney Citigroup), and the highest 16.55% (Macquarie).

The thing to remember is that even though your capital is not at risk, you still have to pay the interest, so you need to be confident that whatever you’re investing in is going to beat that interest rate. “These are useful where people have either no equity in their house, or no house, or little savings that they want to invest,” says Moran. “There’s no cash or asset required up front, just an ability to repay the interest. But the big downside is when you add the cost of protection to the cost of gearing it significantly increases the cost – and so the expected return from the investment in order to be able to make a profit.” Providers tend to argue that tax is an important consideration here, because the interest up to a certain point (currently 10.5%) is deductible. But Moran says: “If I’m going to bring tax into the equation I’m also going to have to look at CGT. Regardless, the expectation [on these products] is of getting above average returns [in order to come out in front], and you should instead be focusing on getting average returns.”

  • Contracts for Difference

Contracts for difference, or CFDs, tend to get a bad rap from planners. “That, to me, tends to be more on the speculating, trading or gambling side of things rather than investing,” says Johns. “I don’t have a lot to do with them.” Moran adds: “As an investment, the possibility of absolute loss of your investment is fairly high. You can lose more than you put in: for small investors they become just a speculative form of investing.”

They get this reputation because of the extremely high level of gearing that they can involve, often as much as 30 times. Anything that highly geared dramatically magnifies your gains – but also your losses.

But providers argue that’s not a fair representation. “I wouldn’t encourage anyone to use leverage for the sake of leverage,” says Gavin White, head of business development at City Index, a CFD provider. “If you’ve got a Lamborghini you don’t have to drive it at 300 kilometres an hour just because you can. There’s a misconception that people are coming to CFDs for the leverage: in fact, the leverage you can get has been around for a long time with futures and options, margin loans and warrants. CFDs are popular for a wide range of other reasons.”

Among those reasons are the variety of asset classes one can access through one account: global financial markets, commodities, currencies, futures and so on, allowing greater diversity in the portfolio. Another is to use them to hedge: if somebody, for example, holds gold mining stocks but doesn’t want exposure to the gold price itself, they can hedge that out using a CFD. For one reason or another, more than 100,000 people are now believed to have CFD accounts in Australia and they are believed to account for as much as a quarter of ASX trading volume.

Nevertheless, they offer the highest leverage available to most ordinary investors. City Index, for example, has a set leverage per product, and on the top 20 Australian stocks, that’s 10 times. In other words, to buy $10,000 of BHP stock, you need to have $1000 on account with City Index. On other products, such as index futures, that leverage can be as high as 50 times.

It is standard practice for investors to limit their losses with features like stop loss orders, which cut off a decline at a certain pre-agreed point. Investors need to be familiar with these approaches, and indeed some providers actually insist that investors take a course to ensure they know exactly what the risks are and how they fit with their own risk appetite.

  • Geared funds

A handful of funds use gearing internally. Probably the best-known examples are from Colonial First State, but they are also offered by AMP, Advance, Ausbil Dexia, BT, Fiducian, ING, Macquarie and Perpetual, among others.  Their returns perfectly illustrate the pros and cons of leverage. The CFS Geared Share Fund through the FirstChoice platform is up 22.24% a year over three years – but down 36.57% in the year to July 31. “They are a great way to achieve similar results [to margin loans] without having to personally manage the loan or gearing facility,” says Johns.




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