Falling markets expose the very real risks involved in venturing into margin loan territory.
By Michael Laurence
When the bear bites
Fund manager Dominic McCormick is no stranger to hearing horror stories about personal wealth being destroyed by investors taking excessive risks with margin loans. And the chief investment officer of Select Asset Management expects to hear many more before the sharemarket recovers.
'Margin loans are much riskier than most people think,' says McCormick, 'and they make sense for only a small proportion of the population.'
The degree of risk for ordinary investors shows up whenever the sharemarket turns sharply downwards and borrowers are forced to sell shares to meet margin calls. 'Australia probably hasn't experienced a bear market like this for 18 years,' McCormick says, 'and this has shocked a lot of people. This is a real bear market and it could fall further. Who knows?'
Perhaps some of the most needless losses witnessed by long-time investment specialists involve investors who are forced to sell quality shares at depressed prices after receiving margin calls during bear markets, only to see the market values of the same shares later fully recover. But when the recovery takes place, those shares are owned by another investor. 'Share ownership transfers from weak hands to stronger hands; that's what bear markets are all about,' McCormick says.
Staggering growth
Growth in the popularity of margin loans to buy listed shares and units in managed funds, using the investments themselves as collateral, tends to track the rising sharemarket during bull markets, says Denis Orrock, general manager of loan and bank product researcher InfoChoice.
Reserve Bank of Australia statistics show that the amount outstanding in margin loans rose by more than 250 per cent to almost $38 billion between March 2003, the month when the market began to take off again after a breather, and December 2007. And the average amount outstanding in margin loans has risen from $87,000 to $189,000 over that time. As share prices shoot upwards, investors become more aggressive.
Margin lending statistics do not reveal anywhere near the extent of borrowing to invest in shares. Other means to gear into shares not covered in these RBA figures include loans using homes and other real estate as collateral, instalment warrants, various other financially engineered products, and internally geared share funds.
McCormick expects the extent of gearing into shares to be 'dramatically higher' than reflected in the RBA's figures for margin loans.
Gearing to invest in shares has commonly been described as a double-edged sword. It is a highly accurate description. On one side of the sword, gearing magnifies returns when share prices are rising. And on the other side, gearing magnifies losses when prices are falling. It's as straightforward as that.
The fundamental trouble is that when markets are accelerating upwards many geared investors forget the less pleasant side of the margin-lending sword.
Borrowing limits
The central characteristic of a margin loan is the borrowing limit or loan-to-valuation ratio that lenders place on stocks in each listed company that they are willing to accept as loan collateral. Each of these listed companies is given its own maximum loan-to-valuation ratio or borrowing limit.
Margin lenders will generally lend 40-75 per cent of the value of shares put up for collateral. The borrowing limit is higher on blue-chip stocks and lower on higher-risk, small companies.
As at 1 April 2008, Australia's biggest margin lender, Commsec, had loan-to-valuation limits of, for example, 75 per cent on each of the big five banks, 75 per cent on Woolworths and Macquarie Group; 60 per cent on Challenger Financial Group; and, an example at the a lower borrowing limit, 40 per cent on Resolute Mining.
Denis Orrock of InfoChoice says the average maximum loan-to-valuation ratio set by margin lenders is about 65 per cent. However, investors, on average, borrow less than 40 per cent of their portfolios' value.
If the value of a share portfolio used as collateral for a margin loan falls close to a portfolio's overall borrowing limit, the investor is moving close to a margin call. Orrock describes this as 'margin loan territory'. And he adds: 'It's tough in margin loan territory.'
Lenders generally allow the value of a geared portfolio to fall below its borrowing limit by a so-called 'buffer' of 5 per cent (some allow 10 per cent) before making a margin call. Then the investor has to come back within the borrowing limit by either selling shares, repaying part of the loan, or offering more collateral.
An investor who borrows to the maximum allowed by a lender will not have to suffer a big fall in the value of the portfolio to trigger a margin call.
Interestingly, the Macquarie Group share price, for instance, fell from a 12-month high of $98.64 to $56.84 at the time of writing. This illustrates the real risks of borrowing to the limit. And some share prices have fallen much further in percentage terms.
Select Asset Management's McCormick has heard of investors who have put themselves in a position of double jeopardy by using margin loans to gear into geared equity funds. These funds have an average level of internal gearing of about 50 per cent, which generally supercharges their returns when markets are rising and does the opposite when markets are falling. Such investors have taken on two lots of gearing on one investment.
Risk controls
Robert Lipman, chief executive of Investec Private Client Advisers, argues strongly that any investor contemplating gearing into the sharemarket at any time should be highly cautious. 'As a wealth-accumulation strategy, gearing can make sense, in certain circumstances,' he says.
Lipman's 'certain circumstances' include gearing for a minimum of four to five years to ride out market downturns; using real estate as loan collateral, rather than shares, to remove the risk of margin calls; borrowing conservatively; and having plenty of life and income protection insurance. And he believes that investors should ensure that the after-tax dividend income from their geared shares is enough to cover the interest payments on the loan.
Paul Resnik, principal of the Paul Resnik Consulting Group and co-founder of investment risk profile group FinaMetrica, recommends that borrowers who decide to take the risk of borrowing to buy shares adopt at least three cardinal rules: invest for the long term, get low-cost finance, and don't borrow to the limit. Resnik advises the finance industry on the development of products including for gearing.
Some investors are now going against the trend in bear markets and actually increasing the size of their margin loans in an attempt to take advantage of depressed prices. This strategy of buying up big when others are selling was famously used in the 1830s by merchant banker Baron Nathan Rothschild who said he liked to buy 'when blood is running in the street'. Rothschild had the distinct advantage of being the world's richest man.
Dominic McCormick of Select Asset Management says panicked and forced sellers are creating buying opportunities in the bear market of 2008, but he says that only highly experienced investors should think about gearing into shares at any time, particularly now.
And any buyers of shares using margin loans at this time, says McCormick, should be confident of not having to sell even if the market were to fall much, much more.
How to reduce the risks
Investors can adopt clever strategies to at least reduce the risks of margin loans. Here are 10 tips compiled with the assistance of leading personal investment and finance specialists.
Adequately diversify your share portfolio: this spreads your gearing and investment risks over a portfolio of companies and market sectors rather than relying on the performance of a handful of stocks. Some high-profile investors have received widespread publicity in recent months for borrowing heavily to buy just a few stocks and somehow managing to pick a trifecta of disasters. Their apparent losses may have been prevented or at least much reduced by having widely diversified portfolios.
Don't borrow to the limit: by giving yourself a 'safety net', you are less likely to receive a margin call. The average maximum loan-to-valuation permitted by margin lenders is about 65 per cent but most investors borrow much less.
Closely monitor your geared portfolio: Borrowing to invest in shares is not a set-and-forget strategy. Closely watch how the value of your geared portfolio is changing in relation to your borrowing limits. If your portfolio's value has fallen uncomfortably close to your borrowing limit, you may decide to voluntarily reduce your level of gearing. By cutting back your level of gearing in your own time, your investment decisions are not being dictated by the margin lender.
Gear for the long term: the aim is to smooth out the impact of short-term market fluctuations.
Prepare for the worst: before taking a margin loan, ask yourself how your portfolio would cope with a sharp fall in prices and a long bear market. The answers may reveal whether you are taking an excessive risk by gearing.
Have a plan in place to cope with a big fall in share prices: know where to raise extra finance to reduce your margin loan if necessary to avoid being forced to sell stock at depressed prices following a margin call.
Take care when prices are rising: investors who automatically increase the size of their margin loans to buy more shares whenever prices rise could be setting themselves up for a fall when the market goes into a periodic downturn. The need for caution at all times should not be overlooked when prices are rising.
Consider neutral gearing: many investors cautiously ensure that their after-tax dividend income is enough to pay interest on their margin loans. This is known as neutral gearing and is a way of placing a personal limit on your borrowing. Historically, the market's average dividend yield has been relatively stable over the long term. Some investment advisers also favour the use of real estate as security to reduce the cost of borrowing, the interest rates are lower, and to remove the risk of margin calls.
Pay interest on time: This will stop interest capitalising and thus increasing the possibility of a margin call whenever share prices sharply fall.
Keep the fundamental maxim concerning gearing foremost in your mind: gearing magnifies gains and magnifies losses.
Asia: a different story
Mainstream Asian investors have not embraced the concept of borrowing to buy shares for one simple reason, the absence of tax incentives for gearing, says Derek Young, chief executive of the financial planning group ipac Asia.
'Margin lending in Australia is driven by tax,' says Young. 'But in Singapore and Hong Kong, tax is not an issue. There is no tax on earnings, no tax on capital gains, and no tax deductions for the interest on investment loans.'
Founded 25 years ago in Sydney and owned by AXA Asia Pacific for the past six years, ipac has 90 employees in Hong Kong and Singapore, including 25 financial planners.
Young says private banks in Asia provide their wealthier and more financially sophisticated clients the opportunity to invest in managed or mutual funds that have internal gearing. 'Again, this is driven by [potential] returns, not by tax.'
These methods of leveraging performance would include hedge funds and structured financial products that use derivatives to put floors or ceilings on performance.
Young says another type of gearing used by investors who are not always experienced or sophisticated includes borrowing from other family members to speculate in Asian markets. Some of these investors, along with investors in a number of hedge funds, would now be suffering from the downturn in the markets.
Asian investors who want traditional margin loans with the use of the shares as loan security would not find products readily available from banks and other financial institutions, as is the case in Australia.
The standard approach for the minority of Asians wanting to gear into shares is to borrow against their properties.
Young says another reason for the seeming lack of interest in gearing into the sharemarket is that many Asian investors take a trading approach to investing in shares, meaning that they buy and sell shares over short periods rather than taking a strategic, long-term approach to their share investing.
However, gearing into the sharemarket requires a long-term commitment to a portfolio of geared stocks.
By contrast, the concept of borrowing to buy investment real estate is widely accepted by Asian investors, and finance is readily available.
What future does gearing into the sharemarket have in Asia? Young expects that this form of gearing will become popular as more Asian investors take a strategic approach and recognise that shares have historically produced long-term total returns that are significantly ahead of inflation. A point to consider is that interest rates in Asia are relatively low.
'The key is education,' says Young. 'This is the gaining of an understanding among investors of the returns that a diversified portfolio can generate over the long term.' This is from directly held portfolios or managed fund (mutual fund) portfolios.
'And then,' says Young, 'lenders will be willing to allow shares to be used as security for loans.'
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