Smart Investor: Gearing, two years after the crisis

Smart Investor, April 2011

It’s been two years the global financial crisis subsided, and many people are wondering if it’s time to take a little risk once again. While investors quickly got comfortable with plain old shares again in 2009 and 2010, one area that has remained subdued is gearing – using leverage to increase your investment exposure. Is it time to reconsider? And if so, how?

There’s no question we’re borrowing less than we once did. “One of the big outcomes of the global financial crisis is a high degree of deleveraging, across the board,” says Mark Johnston, principal of the research group Investment Trends. One of his regular reports looks at the way high net worth individuals invest, and it shows that at the end of 2008, 72% of these investors had some form of gearing in their portfolio. By the end of 2009 it was 60%, and at the end of 2010 it had fallen to 50%.

And the financial planning community, serving ordinary mums and dads, has also become less keen. “There’s a certain proportion of planners who won’t use geared products now – about a third say they’re just not interested,” says Johnston.

Still, product providers speak of a corner having been turned, with people returning to the markets conservatively. “They are ready to gear and they are certainly gearing,” says Peter van der Westhuyzen, executive director at Macquarie Bank. “It’s not to the levels we saw prior to the GFC, and we think that’s a good thing. We have always said a common sense level of gearing can be beneficial, but like everything in life, too much of something is not the best outcome.”

Cathy Kovacs, a Macquarie alumnus who is now building a range of structured investments at Westpac, takes a similar view. “There is still probably more fear than greed. But there is also a recognition from people that, while they can sit in cash and earn 6%, they can also have a growth investment with a responsible level of gearing and protection which allows them to build a diversified portfolio for the long term.”

As people return to gearing, several things have changed about what people want to buy. “Anything that is too complicated, people will be quite wary of,” says Johnston. “There is a move towards transparency and simplicity.”

One area this manifests itself is in underlying assets: where once they might have been distant markets or commodities, it’s mainly Aussie blue chips now. Kovacs says: “People are starting to dip their toes back into the market, and they want things which give them underlyings they understand. So as people move out of cash, they move into Aussie equities. They’re not jumping straight in to hedge funds as they were before.” Van der Westhuyzen agrees. ““One of the biggest changes we’ve seen is that people are doing a lot more due diligence on underlying investments,” he says. “People want to understand what they’re investing into, what the prospects for growth are, and the underlying quality of what they are doing before making a decision on how to fund it.”

Another shift is that people want to be able to get to the exits if they need to. “They want things that are liquid,” says Kovacs. “Previously, many structured products became cash-locked, so they want things they can get out of when they need to.”

When it comes to gearing levels, there has been a shift too – not in capital protected products where 100% loans are still commonplace, since they’re protected, but in others, van der Westhuyzn says the typical range is 30 to 45%. “Pre GFC people were quite comfortable at 45% plus, whereas now they are generally lower than 45 from what we see.”

One area of growth for products is gearing within superannuation. Johnston says about one in five self manager super funds “are interested in” gearing within their fund, “although at the moment the ones who want to borrow are more likely to do so in property than shares.” This is one reason self-funding instalment warrants, discussed below, are gaining favour: they are eligible for use inside of self managed funds. Van der Westhuyzen says there is “a continued climb in the number of people establishing self managed super funds, and with that we have seen an increase in the level of inquiry about how to introduce some leverage into the funds. But when it comes to super people are very conservative in introducing leverage. They don’t want too much super at risk.”

Fundamentally, providers argue that some gearing, done properly, makes sense. “Everyone gears their property,” says Kovacs. They see the benefits of borrowing to buy a home. You can draw the same parallel to the benefits of borrowing to buy shares: and the beauty is, shares are more liquid, you can buy them in smaller amounts and you don’t have to sell the whole lot at once. There’s a lot to be said for gearing into equity markets.”

Instalment warrants

What are they and how do they work?

The premise is simple: buying a share on the lay-by. You buy it in two payments, paying half now and half later. But in the meantime you get access to all the dividends. They are easier than ever to buy since increasingly these warrants are traded on the ASX.

There are dozens of different kinds of warrants – the ASX web site has a useful educational guide – but one common form is the self-funding instalment warrant, in which the second payment is structured as a loan: interest accrues on the loan over time but is also paid down by the dividends.

There’s nothing new about installment warrants but they are making something of a come-back as they are easy to understand. “There’s a little bit of ‘everything old is new again’,” says Cathy Kovacs at Westpac. “They’ve been around for over 10 years.”

How much can you gear?

There is a multitude of product out there; most are geared between about 40 and 65% (for example, Westpac’s new line start out at 50%, meaning that the loan amount will be 50% of the share price). Others have gearing as high as 90%.

What are the risks?

The theory of the instalment warrant is that you can walk away from it, so if the market turns against you the maximum you can lose is your initial investment. Self-funding warrants come with a limited recourse loan, meaning they’re only secured against the shares, nothing else you own. Kovacs argues this approach has some advantages over a margin loan. “Instalment warrants are gearing without the margin calls,” she says. That said, there’s nothing nice about walking away from your investment, and you’d only do it if the underlying shares really crashed.

Who are they for?

They suit people trying to return to the markets and seeking to build a diversified portfolio without the cash to buy everything they want up front. They also tend to suit high dividend-paying stocks, and so investors who like the idea of a yield portfolio. The hope with a self-funding warrant is that they will do so well, and pay such strong dividends, that the loan is reduced and you end up holding the stocks outright without having to put much more cash in.

How have they changed?

Kovacs says that in the range Westpac is offering, payment is not due for five years in order to align with longer-term investment objectives – that’s longer than typically used to be the case. (Another type of warrant, the rolling instalment, can go as long as 15 years.) That said, being listed, they can be sold at any time. Another change is their increasing use to leverage into exchange-traded funds as well as big blue chip stocks. Also, levels of gearing are more conservative than they used to be.

Margin loans

What are they and how do they work?

With a margin loan, you borrow money to invest in shares (and sometimes a few other things like managed funds). Your loan is secured against investments.

When margin lending works, you increase your gains, more than covering the interest you’re paying on the loan. When markets go against you, losses are multiplied and you can be subject to margin calls.

How much can you gear?

Lenders use a calculation called the loan to value ratio to calculate how much gearing you can use. So, if you had an LVR of 70%, then in a $100 investment, the lender would give you $70, and you would put in the other $30.

Some providers officially still have a maximum LVR of 100%, and most have a stated maximum between 75% and 90%, but in practice it would be unlikely for anyone to lend you more than 70%, especially in this environment. Common gearing levels today tend to be around 50% or lower.

What are the risks?

The bugbear of the margin loan is the margin call. Let’s say you have a maximum LVR from your lender of 70%, and so you’ve set out with a LVR of 60% to be on the safe side. The problem is, if the value of your shares falls, then by definition the LVR will go up, and if it passes the maximum, you will be told to top up the difference with your own cash. This is a margin call. If you don’t have the cash you can start selling the shares, but it stands to reason this will be the worst time to do so as the value of those shares has fallen. Remember you will also be paying interest on the margin loan, typically 8 to 9.5% at the moment.

Who are they for?

Margin loans suit people who want to build exposure to the market off a limited outlay of cash – but they only make any sense if you have a strong view the market is going to increase in value by more than the interest you are paying on your loan?

How have they changed?

Lately, by getting less popular. “The margin lending industry is very flat at the moment,” says Johnston. “There were very subdued levels of new business being written pre-December” – and in December new regulations came in making margin lending more complicated, which is likely to dent new business further. In 2007, 76% of financial planners were providing advice on margin lending, according to Investment Trends; by the end of 2010, 58%. Additionally, some established providers – notably Macquarie – have pulled out.

Capital protected loans

What are they and how do they work?

You get a loan and invest it into Australian shares, generally from an approved list from the lender. You choose a term for your loan – typically one to five years. The hope is that the capital growth and dividends from the loan allow you to pay it off and come out ahead; if the reverse happens, you can surrender the shares to pay off the loan, even if there’s a shortfall, meaning all you’ve paid is the interest.

How much can you gear?

These loans are often 100% – meaning that everything in the investment is a borrowing.

What are the risks? If the market falls, you surrender the shares to discharge the loan – and unlike in an instalment warrant or margin loan, you never put in your money to buy the shares in the first place. That doesn’t make them completely risk-free, because you will still be on the hook for the interest payments during the course of the loan, which will be higher than a regular loan because of the cost of the capital protection. That said, these loans don’t get cashlocked like some other capital protected investments (see below): if the market falls in the first year of a three year loan, you still own the same shares, and get to benefit if the market rebounds in the next two years.

Who are they for?

“One thing we can see without a shadow of a doubt is that people do value protection,” says van der Westhuyzen. “And they do value limited recourse lending, just in case something does go wrong – like in the last few years.”

Capital protected loans are also permitted within self-managed super funds.

What’s changed? “There is a revival in protected equity lending,” says Kovacs. But from the bank perspective, they are generally only prepared to lend over fairly conservative Australian shares these days.

Capital protected structured products

What are they and how do they work?

All the rage before the financial crisis, these products usually offer a return linked to an investment or market, and promise that even if the investment doesn’t work out you should still get your original commitment back at the end of the term.

How much can you gear?

Often these products are linked to loans, meaning that as much as 100% of the investment amount might be lent to you.

What are the risks?

The risks became very clear in the financial crisis. One is being cash-locked. In order to provide capital protection, many products had a feature in which, if the main investment fell too far in value, the whole lot would be switched into cash, in order to make sure you got your money back at the end of the term. While this stopped people losing money, it also meant that for the rest of the investment term – sometimes as long as seven years – their money was sitting in cash earning very little while markets were rebounding and they were still having to pay heavy interest on their investment loan. Other risks included liquidity – not being able to get money out of products even if they wanted to; or the provider of the capital guarantee going under, thus rendering it useless (this happened a lot when Lehman Brothers collapsed).

Who are they for?

They don’t have much of a fan club these days, but they do have some advantages. They can give you exposure to asset classes, like emerging markets equities or commodities, that you couldn’t otherwise reach. If they work, they can enhance a return. And you will at least not lose your initial investment, though don’t forget the interest costs.

How have they changed?

This is the area with the greatest degree of change. Firstly, products that can be cash-locked have all but withered away. “We are not issuing any [products with that potential] and I haven’t seen any recently,” says Kovacs. “The feedback is that people aren’t interested in them at the moment.” Secondly, underlying assets have tended to become more simple, such as Aussie equities instead of far-flung foreign ones. Thirdly, there are more assurances on liquidity. But generally, they’re just less popular. According to Investment Trends, only 24% of planners are currently providing advice on these products, down from 33% in 2007.

Contracts for difference

What are they and how do they work?

CFD trading allows you to make highly geared investments on a range of things – stocks, currencies, bonds, commodities, markets, you name it. Some call CFD trading ‘spread-betting’. You put a small amount of money in, and get far greater exposure, magnifying your gains if you do well and your losses if you don’t.

How much can I gear?

It’s not uncommon to be able to borrow 95% of the value of a contract, putting down just 5% yourself. That’s 20 times gearing – meaning if the thing you’re investing in goes up by just 1%, you’ve actually made 20%. If it goes down 1%, you’ve lost 20%.

What are the risks?

Clearly that CFDs magnify losses enormously. And they can just keep going – losses are, potentially, unlimited. In practice, many people use something called a stop-loss, which kicks in to exit a trade before too much is lost; this does help manage the risks. We also hear that CFD providers tend to intervene in declining trades before they get too far out of hand because they don’t want to run the risk of not getting their money back. But CFDs, used without a proper risk management framework, can be highly risky. As ASIC says: “You’re effectively gambling a much larger amount of money than if you went to the casino or racetrack.”

Who are they for?

While CFDs do offer easy gearing, relatively few people use them for that purpose over the long term. “CFDs are much more about short-term trading,” says Johnston. “It’s rare for people to hold CFD positions open for any length of time: a lot is intra-day and much of the rest is within a week.” Indeed, it should be pointed out that some people only use CFDs for risk management in order to hedge other positions they have.

How have they changed?

The number of CFD users has grown dramatically over time: according to Investment Trends there were 39,000 active users in Australia in May 2010, up from 32,000 the year before, and 26,000 the year before that. In terms of evolution, people do appear to be getting smarter about how they use them, with the use of stop loss techniques increasing.