Borrowing Billions On The Margins
Sun Herald
Sunday July 21, 2002
THERE has been a boom in borrowing to buy shares, with a 30per cent increase in margin lending over the past year.
According to the Reserve Bank Bulletin, the average margin loan is almost $90,000, which means $10billion has been borrowed by nearly 110,000 investors for assets that are losing value by the day, with even some of the bluest of blue chip stocks going backwards.
There has been a further trend of investors moving out of shares and into borrowing to invest in professionally managed investment funds. In 2000, investors used margin lending or gearing in a 75:25 ratio of shares to managed funds. In the year to March, the proportion into managed funds increased to about 60pc.
Financial advisers like to push the idea of gearing investments, possibly because they stand to gain higher commissions from the larger amounts involved in borrowing to invest. And more small investors are being enticed into borrowing as a way of gearing up or boosting their capital to buy shares and managed investment funds.
Many are deciding that leaving the stock-picking to professionals is one way of playing it safe in a nervous market.
The traditional way of borrowing to invest was against either your home in a home equity loan line of credit, or against cash or the shares you own (usually limited to 50-70pc of the investment).
For the smallest punters, gearing is wrapped up in managed funds such as Colonial's Geared Share Fund, which does the borrowing for you within the fund. Now there are savings and loans plans that can be started with as little as $1,000. Macquarie Bank, National Australia Bank, St George Bank, the Commonwealth Bank's broking arm CommSec, BT and Leveraged Equities offer instalment gearing loans.
CommSec's margin loan with regular gearing lends you $2,000 if you contribute $2,000 in cash or existing shares, making $4,000 in total. This is invested automatically in one or more approved managed funds you choose from a menu they provide.
Each month you invest a minimum of $250. For each dollar you invest, CommSec lends you a dollar, doubling your investment power making $10,000 after a year.
The strategy is good for people who do not have a large sum to initially invest but have a solid level of ongoing cash flow.
The only problem with accelerating your investments is it works both ways your gains are greater but so are your losses.
``People are desperate to save more for the future and that's commendable," said Rashmi Mehrotra of Van Eyk Research.
``But do not get carried away the basics are that it does not make sense to borrow at 10pc for investments that return 8pc in the long term."
But Peter Thornhill, of financial consultancy firm Motivated Money, said gearing your investments was a good idea at any time.
``Most businesses run modest debt on their balance sheet good businesses can invest to generate a return which is greater than the net cost of interest," he said.
``The key word is modest companies which overborrow can get into real trouble. With investors it only becomes a hazard when you overborrow. As long as you keep your debt at a reasonable level, margin lending products are good in down markets."
The idea is to pick stocks that beat the average. Professionally managed funds have consistently given 2pc better returns than the market.
If you had invested $5,000 in the Colonial First State Australian Share Fund in July 1991, after 10 years your holding would have increased to $25,756. If you invested $5,000, and contributed an additional $250 a month, after 10 years your investment would be worth $95,860.
But if you used a margin loan with regular gearing to double your investments, after 10 years your holdings would be worth $156,970 an effective annual rate of return of24.9pc.
The CommSec interest rate is 7.99pc compared with 7.4pc for its regular margin loan. Using your house as guarantee, the home equity line of credit rate is 6.57pc.
Thornhill says his preferred prudent level of borrowing or gearing to assets is 50pc, which is usually sufficient to prevent a margin call when the falling market value of assets requires the lender to stump up cash or sell stock to meet equity level.
It pays to be conservative. If the market goes backwards gearing can make things worse.
Macquarie Bank has capital protected, 100pc loans of $50,000 to invest in a menu of 10 managed funds for five years and no margin calls. The interest rate is 8.7pc, which is about 1pc above the usual margin loan rate and 2pc over the secured loan rate.
TIPS TO GIVE YOUR INVESTMENTS A LEG-UP
* Keep your borrowing to 50 per cent or less of your shares' value. This will limit potential losses and reduce the likelihood of a margin call.
* An instalment margin loan lets you buy shares by ``averaging" into the market. As shares fall you acquire more assets for a given investment and as they rise so does the value of your existing holdings.
* Have ready access to cash to meet margin calls so that you are not forced to sell shares if prices plunge.
* Diversify to reduce risk. This can be achieved easily with the use of managed funds which can offer diversification across asset classes, across countries or regions and across fund manager styles.
* Only buy shares that are easily traded in case something unforeseen happens and you need to exit the investment.
* Consider a fixed-rate investment loan.
* Take out income protection insurance to cover the risk of being disabled and unable to work.
* Consider taking out life insurance to allow the loan to be repaid on death. The investments can then be transferred to your beneficiaries upon death.
Source: MLC
WHEN IT'S TIME TO CHANGE GEARS . . .
* Margin lenders use your shares as security for their loan. That's why the rate is lower than on a personal loan, though higher than the mortgage rate you get on equity loans.
* Depending on the stock, and the lender, you can borrow up to 80pc of the cost of your shares. But if, say, your shares drop, you're now borrowing more than 80per cent of their value.
* So your lender will insist you cough up some cash to bring you back to 80pc. That's a margin call. The lower your percentage of gearing the less likely you are to have a margin call.
© 2002 Sun Herald