Geared funds magnify gains – and losses

Smart Investor magazine, October 2008

These volatile times might seem an absurd moment to gear into the stock market. As every investor should know, the golden rule of leverage is that just as it magnifies gains, it magnifies losses too. So who would try increasing their exposure at a time like this?

Well, if you think markets are still heading down, then you shouldn’t. But if you think we’re at or near the bottom of the market, then gearing strategies start to look more attractive, albeit risky. Then, you get the benefits of the bounce back in the markets when it comes, and that benefit is multiplied by leverage.  

This quarterly column will look at a different leverage issue each time, and we start with a comparison of margin loans and home equity facilities like a line of credit. Future editions will look at capital protected loans, geared managed funds, and contracts for difference.

Margin loans simply involve borrowing money from a broker to invest in shares. You can use them to invest in one stock, a range of stocks, and usually in mutual funds as well. That allows you to create a diversified portfolio reasonably simply.

Advantages of margin loans include the speed of getting them set up; their transparency; and their simplicity. It’s commonplace to be trading with a margin loan 48 hours after applying for it, and it’s not unheard of to be up and running the following day. They can also carry tax advantages. Disadvantages are that they cost more than home equity, and the danger of margin calls.

Let’s deal with the cost side first. Most people go for variable rate products, which currently are charging around 10 to 10.5%, so 1 to 2% more than you’re probably paying on your mortgage (naturally if the Reserve Bank keeps cutting interest rates, these rates should fall too). Often, the rate varies depending on how much you borrow: BT Margin Lending’s Standard facility, for example, charges 10.4% from $20,000 to $499,999, and goes down as far as 9.4% – but you have to borrow $1.5 million before you get that rate.

The important thing to remember about margin loans is that you need to be confident about beating this rate with your returns, and if you’re not, don’t get one. Your returns, though, don’t just mean the increase in the value of stocks in your portfolio, but your dividends too: it’s a common approach to use the dividends to help pay down interest, and consequently many people who get margin loans focus them towards high-yielding stocks like banks and Qantas.

There’s a tax consideration too. Generally, the cost of the interest on a margin loan is tax deductible. Some people find it advantageous to pre-pay that interest. Everyone’s tax situation varies so you need to get independent advice, but when the tax offset is factored in to the equation it makes it easier to reach that hurdle that makes a margin loan make sense.

But what about margin calls? This happens when the value of the stocks you hold falls below a certain amount, an amount that will depend on how highly you geared in the first place. If the value of the stocks you bought with your loan fall too close to the value of that loan, your provider can ask you to either commit more money, or sell some of your shares. That’s a margin call. Logically, the more heavily geared you are, the quicker this happens when markets fall down. For this reason, many providers recommend not gearing to more than 50%, though some allow you to go much higher. Remember, too, that if you do get hit with a margin call and have to sell your shares, it will probably be the worst possible time to sell.

Margin lending providers are quick to caution about the idea of timing the market. “Gearing is a long term strategy,” says Craig Keary at Westpac. “When people undertake gearing, they need to undertake that for the longer term.” But he does think that this is a good time to be considering a margin loan. “If you say you’re going to take long term investments in a diversified portfolio of solid blue chip companies, with a sensible gearing level, it is a very good time to start looking at gearing.”

Then there’s home equity, most frequently used through a line of credit facility. A line of credit means you use your house as security against a loan, and use that loan to buy shares. In truth, you could use a redraw account too, but there is an advantage to using a separate line of credit facility because it helps you to separate interest costs related to share purchases from the rest of your mortgage, which is very important at tax time.

Perhaps the biggest advantage home equity has over margin loans is that nobody is ever going to contact you with a margin call. Even if share prices fall heavily, as they have recently, you can patiently bide your time, ride out the storm and wait for things to bounce back again. They also tend to be cheaper, generally between 8.5% and 9.5%. And if you want to you can generally borrow more than with a margin loan, up to 100% of the home equity value.

However, there’s no tax offset deal for the interest with a home equity loan, unlike a margin loan. It takes longer to set up, sometimes six weeks or more, and there are other costs involved like mortgage stamp duties.

Planners tend to be more positive about this approach. “We tend towards home equity,” says Darren John, a certified financial planner at Align Financial. “It has the greatest control and the greatest scope. With a margin loan you can be halfway into a 10 year plan, with the idea to sell your assets at the end when you’re in a marginal tax rate, and can find yourself forced to sell assets at a terrible time.”

We asked Infochoice to do some modelling on the two different approaches to compare the costs involved. We assumed a $30,000 loan, for someone on the 30% tax rate, investing it across BHP Billiton, the Commonwealth Bank, Qantas and Telstra. As you can see from the table, the margin loan works out as about $300 more expensive per year than the line of credit, even when the application fee for the home equity is taken into consideration. But after tax is taken into account, the difference is smaller. These costs are what you need to beat in capital gains and returns in order to come out ahead with a loan.