Scott Francis 11 March 2013

Summary: Demand for margin loans reached its peak during the Global Financial Crisis. A geared share portfolio can become self-funding over time if dividend income exceeds the loan interest costs. But there are no guarantees, and borrowing to invests means you are forgoing defensive assets in your portfolio.

Key take-out: The essential feature of gearing is to have a long-term strategy ... at least five years

Margin loans are loans put together allowing people to borrow to invest in shares. They have a number of specific characteristics including that they will usually lend to a certain value against any security (the loan to value ratio), they can force the sale of your shares if the loan falls below this value (the margin call) and they generally have interest rates higher than a housing loan.

Currently, according to Reserve Bank of Australia figures, there is about $12 billion borrowed on margin loans – the lowest amount for 10 years. The following table charts the growth and subsequent decline of margin loans.

Margin Loans Outstanding ($ million) December Quarter (RBA)
2003	$12,502
2004	$15,524
2005	$20,827
2006	$30,823
2007	$41,589
2008	$23,440
2009	$21,608
2010	$19,240
2011	$15,078
2012	$12,235

One insight that the table provides is just how poor investors are collectively at ‘market timing’. When the market was at its peak (December 2007) margin loans hit their collective peak of over $41 billion. Investing at this time – the top of the market – has led to terrible subsequent returns. However, by the time the market bottomed in the March quarter of 2009, only $21 billion in margin loans were outstanding – at a time when subsequent returns have been very good. To create wealth, investors should have done exactly the opposite, having smaller loans in 2007 when the market was high, but borrowing to invest when markets were low in 2009.

The decline in margin loans outstanding has not reversed, even as market indices have risen from their low around the 3,000 point mark to their current level around the 5,000 point mark. Indeed, the value of margin loans outstanding has continued to fall.

I think there is some collective wisdom at work here. No doubt there is greater caution after the collapse of Opes Prime and Storm Financial, however I suspect there is further dissatisfaction from margin loans that come from four key areas:

The ever-present threat of a margin call;
The cost of the loans (interest charged);
The ability of the lender to change the LVR; and
An investor’s exposure to volatility and the risk of losing all their investment capital.

The threat of a margin loan

Margin calls are potential wealth destroyers. A margin call occurs when the value of a portfolio has dropped too far and, in the lender’s opinion (through the LVR that it set) it is getting too close to the value of the underlying portfolio. When a margin call is made the investor has to add extra cash or approved assets (eg approved shares or managed funds) to their margin loan facility. If they don’t they will have their investments forcibly sold. This forced sale happens, by definition, at the worst time for investors – when investment values are low. It can be a disastrous outcome – and one that happened to investors during the Global Financial Crisis as investment and portfolio values plummeted.

The cost of the loan (interest rate)

I have just had a look at my own bank. Currently its one-year fixed margin loan rate is 7.6%, while its one-year fixed home loan rate is 5.2%. This is a big difference in interest charged – more than 2% a year – which I find to be the usual gap between a loan secured by property and a margin loan. My question is, are margin loans really that risky for banks that they need to charge an extra 2%-plus in interest (or $2,000 a year on a $100,000 margin loan)? Given that the underlying assets of a margin loan are particularly liquid (can be sold easily for cash), and the bank has the right to forcibly sell the assets if the portfolio values drop, I am not sure that the extra interest cost of a margin loan is justified.

Changing loan to value ratios on investments

One issue that margin loan investors might have encountered is that the margin lender has the right to adjust the LVR of assets that it will lend against. This can be very difficult for investors. If they own an investment in which the bank suddenly reduces its willingness to lend against, the investor needs to find more money, add investments to the margin loan or sell some investments. This is all because the margin lender adjusted the extent to which it was prepared to lend against an investment.

The risk of losing everything

A LVR of 50% is often described as a more cautiously geared portfolio. This would mean that in a $200,000 portfolio, $100,000 would be borrowed money. If, as happened during the GFC, you owned share investments and shares fell by 50% (as they also roughly did in 1987, in the 1970s, and during the Great Depression in Australia) your $200,000 portfolio would have turned into $100,000. You would have been left with effectively a $0 position as your $100,000 portfolio and $100,000 loan would cancel each other out. In reality, if you have no other cash or investments, you would have been a forced seller of assets as your portfolio dropped in value and the LVR decreased – not a pretty scenario at all.

The solution – if you need to borrow

These four issues considered, what might be a better option if you particularly wanted to borrow to invest in shares.

One answer worth considering is to take advantage of the increasing flexibility in loans secured by your home to borrow and invest. With lower borrowing costs, no margin loans and various options for offset accounts and variable and fixed terms, they are likely to offer a good option for anyone.

However, borrowing to invest still carries the risk of magnified losses. The more conservative option of investing regularly over time, using your own money, should not be forgotten.

A Clear Direction Financial Planning