A tool that could make all the difference

So much has been written of Australians’ hearty appetites to endure debt in pursuit of property, that an argument that leverage is also a popular mechanism in the equity market would be unlikely to surprise anyone.

It’s certainly no revelation to financial advisers, who for some time have successfully recommended strategies like margin lending to clients keen on increasing exposure to the share market.

Yet contracts for difference (CFDs), a relatively newer margin product that is steadily gaining acceptance among traders and investors, has featured less prominently (if at all) in advisers’ discussions.

But according to Andrew Leelarthaepin of CFD provider Man Financial, the spike in CFD up-take should be enough for advisers to sit up and take notice.

Growing market

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“Growth in the CFD market has been phenomenal … there are now over 20 providers,” Leelarthaepin said.

“It is estimated that between 5 and 10 per cent of trades on the Australian Stock Exchange (ASX) are CFD-related.”

He added that Man Financial predicts CFD-related turnover on the ASX could increase to 20 per cent in the next three years.

Other CFD providers like First Prudential Markets and CMC Markets have both also noted a doubling of the CFD market each year.

According to First Prudential Markets managing director Matthew Murphie, CFD transactions make up about a third of trades in the UK, foreshadowing their potential growth in Australia.

CFDs unravelled

A CFD is a contract between two parties to exchange the difference in the price of a security between when the contract opens and when it closes.

Known by institutional investors for over 20 years as equity swaps, one of the main attractions of CFDs is they allow investors to open a position without outlaying the full value of the shares in that position. They do this by outlaying a deposit pledged as collateral to the CFD provider, with the provider effectively financing the remainder of the required outlay.

In this way, CFDs allow investors to trade shares on margin without having to physically own them.

For example, in order to purchase 5,000 shares at $10 using a CFD, an investor may only need to outlay a 5 per cent margin rate plus commission, around $2,500, in order to gain market exposure of $50,000. Providers thus spruik that for a fraction of the cost of the shares, investors stand to benefit as though having purchased them entirely.

Head of Macquarie CFDs Dan Semmler argues CFDs can also help in portfolio diversification.

“People are using [CFDs] to diversify by using leverage to get a larger spread than they otherwise could,” he said.

While the benefits, and inherent risks of, leveraged investing are nothing new to advisers, where CFDs differ is in an ability to offer more sophisticated trading positions, such as long and short selling.

“A major advantage of CFDs over share trading is the ability to ‘short sell’,” Leelarthaepin said.

“It means traders can profit from falling markets just as easily as they can from rising markets and the brokerage is the same.”

Since an investor does not own the underlying stock in a CFD scenario, they can benefit from a fall in share price by selling the stock and buying it back at a lower price.

While CFDs are generally classified as an aggressive investment option, CMC Markets director Brian Griffin argued the product is more versatile than that.

“CFDs can also act as a hedging mechanism. I can minimise my risk without having to liquidate my share portfolio,” he said.

Leelarthaepin agrees: “If you think the market is going to fall, you could short sell CFDs in the same stock, which would reduce your exposure to the market and protect your capital. The effect of the drop in share price is effectively neutralised by the CFD.”

Short selling offers further benefits, with most CFDs structured such that CFD providers pay interest to the holder of a short position. (Although, in reverse, holders of a long position incur an interest charge.)

“Essentially a client gets to hedge their position and is paid to do so — that’s a pretty attractive offering,” Murphie said.

Another strategy made possible by CFDs, Leelarthaepin said, is pairs trading, where investors can profit from expectations on the performance of two related stocks in the same sector.

Not for the faint-hearted

Aside from the range of sophisticated investment instruments made possible by CFDs, providers contend that the most persuasive reasons for their popularity include their transparency and simplicity.

In particular, with some CFD models directly replicating ASX prices, Murphie believes investors with a background in share trading can move comfortably to CFDs.

However, CFD-providers point out that the involvement of concepts like short-selling and leverage possibly make the product better suited to ‘savvy’ and experienced investors.

“CFDs are for the sophisticated trader who [have] experience in trading shares or other derivative products,” Leelarthaepin said.

“People need to be educated about the product, they need to limit their exposure and manage it.

“It is important to note that CFDs are a highly leveraged product and carry a high level of risk.”

According to Griffin, CFDs have thus far tended to be adopted by high-net-worth individuals, although he says that as awareness grows, there is more and more interest “at the edges”.

A role for advisers

But as an increasingly financially literate public becomes more aware of CFDs, are financial advisers in a position to provide advice?

A number of dealer groups contacted for this story were either unaware of the product or did not have it on their approved lists.

Murphie said First Prudential Market does receive some CFD business through the adviser network, although less than what he’d like to see.

“Planners are perhaps more focused on what they’ve been doing for a long time rather than being quick to move on a new product,” he said.

“CFDs are still in their infancy in terms of growth … planners tend to look to more traditional products.”

Lack of understanding about CFDs is a key barrier, Macquarie’s Semmler said.

“Some advisers have a misconception that CFDs are purely a punting product,” he said, countering that the range of strategies made possible by CFDs, such as hedging and long and short selling, show them to be far more versatile.

The irony of the lack of understanding and awareness, according to both Murphie and Semmler, is that advisers have an important role to play in partnership with CFD providers.

“CFD providers are purely product providers — it’s a non-advisory position,” Murphie said.

Semmler added: “The crucial element for advisers to be involved in is the advisory role … advisers can step in and advise if the product is appropriate for clients and suits their risk-reward profile.”

However, awareness does appear to be growing, not least because of greater demand from clients.

“There has been an increasing level of interest from financial planners and advisers in CFDs,” Leelarthaepin said.

“Clients wanting to know more about the product are generating this demand.

With CFD providers committed to educating advisers about CFDs, Griffin predicts every adviser will at least know what a CFD is within 18 months.

“There’s no need to teach them how to bake potatoes, but it’s worth educating them on the technical aspects of CFD trading, the suitability of the product, the opportunities they can offer, and their complementary role within a basket of investment products,” he said.

Leelarthaepin has already noticed a change for the better.

“One year ago, less than 1 per cent of business came via financial planners, whereas now over 10 percent of CFD business comes via dealer groups and financial planners,” he said.

Trading methods

There are two distinct trading methods for CFDs: direct market access (DMA) and the market maker (MM) model.

Under the DMA model, providers purchase stocks on the exchange, and offer prices identical to the underlying market. With MM, CFD providers create a synthetic market, where prices can potentially differ from that of the underlying market.

Murphie warned investors to carefully consider the impact that differences in prices offered by DMA and MM providers can have when evaluating the overall costs of CFD trading.

Aside from the models offered, Griffin urged advisers to also consider the broader capability of CFD providers.

“Advisers need a lot of support — technical, software-related, education, etc,” he said.

“The ability to provide these things is a good sign of the size and breadth of the organisation.”

Semmler added that the nature of CFD trading means advisers must carefully assess the durability of providers in the interest of the risk and security of their clients’ funds.

“CFDs aren’t listed on the exchange, they are an over-the-counter product,” he says.

“It’s basically a contract with the CFD provider, so questions about how long a CFD provider will remain in the market become important.”