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 Margin loan? Think again - Eureka Report Article 

April 7, 2008
Margin loan? Think again
By Scott Francis

PORTFOLIO POINT: Investing regularly in growth assets is a powerful and simple wealth-creation strategy free of the risks of margin lending.


Recent statistics from the Reserve Bank show that in the December quarter Australians had $38 billion of margin loans. This was up from $4.7 billion in the June 1999 quarter and highlights just how fast margin lending has grown as a wealth creation strategy.

Margin lending has featured in the news a lot lately, thanks to the collapse of Opes Prime and directors of companies including ABC Learning, Allco and MFS being forced to sell holdings at low prices because of margin calls.

So how do margin loans actually work? And should investors consider using a margin loan in given current market conditions?

The basics

Margin lending is the term used to describe borrowing to invest, generally in shares, listed property trusts and managed funds. A margin loan is secured against these assets, and allows lending to a certain level, depending on the margin lender's assessment.

Many "blue-chip" companies will be given a loan to value ratio (LVR) of 70%, which means that 70% of the value of a holding can be financed by the loan. For example, a $100,000 investment in a portfolio of blue-chips could include $70,000 of borrowed money. If the value of the shares falls, the $70,000 is now worth more than 70% of the investment, so exceeding the maximum allowed. Then a "margin call" is made - to get the LVR back under the maximum - and the investor has to provide further cash (often by selling shares) or investments to secure the loan.

An interesting twist on this, which catches investors out at times, is that margin lenders can change the LVR of a security. Often this happens at the worst time - after a sharp fall in the price of the particular security. An investor is then hit with a double-whammy: as the value of their holding falls sharply and the margin lender is no longer prepared to lend as much against the stock, the investor then has to scramble to stump up either cash or more investments to put off a margin call.

Issues to consider from the current market

Borrowing to invest is touted a powerful wealth-creation strategy, and indeed it can be. But a word of warning: it can be a powerful wealth-creation strategy for your financial planner or stockbroker as well. For example, consider a situation where an investor who has $100,000 to invest is encouraged to borrow a further $100,000. A stockbroker who charges 0.75% on trades can now charge their fee on a $200,000 portfolio rather than $100,000. The stockbroker gets twice the brokerage and picks up the trailing commission on the margin loan.

The downside of borrowing to invest is that the strategy accentuates both positive and negative market returns. With the market currently down about 19% from its highs in the second half of last year, investors who geared into the market with an LVR of 50%, which many commentators describe as "conservative", would have seen the actual value of their portfolio fall by 38%. At times this year, the value of their equity in the portfolio would have been down 50%.

If we look at times when markets have fallen even further, such as the early 1970s or the 1987 sharemarket crash, such market downturns would see investors who have an LVR of 50% lose almost all of their capital. I am not sure this risk is discussed with margin loan clients who have a 50% LVR - that based on historical market returns, there are times when they could have lost their entire outlay.

The current environment is a difficult one for margin investors. Interest rates are around 10.5% for the average margin loan and markets have fallen sharply. This sort of "crunch" is not uncommon, as high interest rates can negatively impact the value of shares because of the higher borrowing costs that companies face.

The worst outcome for a margin investor is forced selling. This is because forced selling (usually due to a margin call) happens when markets have fallen sharply in value. Worse still is the situation where an investors is holding a portfolio with relatively few securities, with one of those falling very sharply in value (for example, ABC Learning) and the margin lender decreasing the LVR of that asset.

An understanding of this risk, and a plan to provide more cash or investments for the loan, is worth having in place.

Another subtle issue to consider with using a margin lending strategy is how the loan is eventually going to be repaid. With a margin loan strategy you are effectively forgoing investment income (by offsetting the income in your portfolio against the interest repayments of the loan), in the expectation of an eventual capital gain in the portfolio. Ideally, however, you don't want to have to sell any assets in the portfolio and pay capital gains tax to finally repay the loan. There would be many margin loan investment portfolios at the moment that have more than doubled in the past five years, which would mean significant capital gains tax if assets had to be sold to repay the loan. Having a strategy to repay the margin loan debt without selling shares, for example in the last 10 years leading up to retirement, can save the capital gains tax bill.

Another issue to consider is whether you should be using a margin loan at all. The Cannex website lists margin loan borrowing rates starting at about 10%, and commonly at about 10.5%, well above mortgage rates that start at about 8.5%. There is a significant advantage for borrowers to consider securing an investment loan against their home rather than a margin loan. They will save money on the interest repayments and remove the risk of a margin call. Care needs to be taken in understanding the impact of securing an investment loan against a home.

My opinion is that one of the most powerful wealth-creation strategies is to regularly invest over time in growth assets. This strategy allows the investor to keep buying more assets when prices are down, as they are now.

Investing regularly in growth assets is a powerful and simple wealth-creation strategy that does not involve the risks of margin lending - such as a margin call, losing all of the value of their investment and multiplying the downside volatility of markets. That said, borrowing to invest does increase the expected long-turn return of a portfolio, and was a lucrative strategy during the past five years of above-average returns.

Conclusion

The market downturn has raised many interesting questions - with discussion of stock lending and short selling among them. We have also seen many directors being forced to sell company shares that have been bought with borrowed money. Thought needs to be given to how well directors with large margin loan-funded holdings have their interests aligned with directors.

Rising interest rates and falling sharemarket values have also seen individual investors with margin loans under pressure. A thoughtful approach must be taken in weighing up the risks and rewards of using a margin loan to invest.
Scott Francis' articles in the Eureka Report 

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