Margin lending has gained a bad reputation in recent months.

The aggressive advice handed out by a particular group of financial planners has sparked a parliamentary inquiry into the banking and financial services sector.

Meanwhile, even investors who thought they were in safe territory have found themselves facing margin calls.

Australian Bureau of Statistics (ABS) figures show that the number of margin calls made to clients jumped from 790 in December 2007 to 9,770 in December 2008. Among those were serious instances where clients not suitable for such an aggressive strategy have faced significant, and in some cases, catastrophic losses.

Not all cases of margin lending have ended in disaster though. For a specific type of client, this strategy can prove lucrative. But it is a style of investing that should never be undertaken light-heartedly.

Growth in margin lending

During the boom years many investors — and their financial planners — identified themselves as ideal candidates for margin lending.

At the turn of the century, ABS records reveal there were around 80,000 to 90,000 investors with margin loans.

As global share markets tanked last year, there were more than 200,000 investors with geared investment exposures. But in an environment where positive market movements meant ever-reducing loan to valuation ratios (LVRs) and ever-increasing asset bases, it is easy to see why the idea was seductive.

Even the regulator conceded that trying to warn people of the dangers of margin lending during bull market conditions was an almost futile task.

In its statement to the joint committee into financial services and banking, the Australian Securities and Investments Commission(ASIC) said while it had been concerned about instances of aggressive leverage, and had issued general warnings to retail investors, the bull market “masked any potential shortcomings in an aggressively leveraged advisory model”.

“Consider the difficulty of ASIC trying to close down an advisory model in 2006 or 2007 which was producing high returns for its investors,” the regulator’s statement said.

But now investors and financial planners are facing a bear market and the prospects of rising unemployment and falling dividends. Now is perhaps the best time to reassess what a real margin lending client looks like, and the steps advisers must take before recommending such an aggressive strategy.

Time horizon

One of the initial litmus tests that can be applied to potential margin lending clients is their time horizon.

Fiducian Portfolio Services technical manager Andrew Biviano, ThreeSixty technical services manager Gemma Dale and ipac head of technical services Colin Lewis all agree that a minimum five to seven-year time frame is vital for a margin lending client, while AXA’s technical services manager Ryan Krawitz believes a five to nine-year range is an appropriate guide.

This time frame is essential to allow clients the opportunity to ride out any fluctuations in the market, and ensure they are not forced to sell assets and crystallise losses during a period of poor returns.

“If the market drops 40 per cent you need a long, long time to make that money back,” Dale said.

Another key consideration, and one that also relates to a client’s ability to maintain a margin lending strategy through volatile markets, is their available cash flow.

This is an aspect that may have been taken for granted over recent years, with some investors relying on dividends from the portfolio to fund interest repayments. In this situation, any fall in asset value, dividend cuts, or interest rate hikes will impact the investment yield, leaving the investor exposed.

Both the industry and investors became too comfortable with the concept that both dividends and interest rates are stable, Dale said. She believes many people “have really underestimated how critical cash flow is in these situations”.

Investors must be able to continue making interest repayments “even if the investments you have in that portfolio go to zero”, Dale said.

Therefore any clients undertaking these strategies must have “exceptionally strong cash flow that is close to guaranteed”, Dale said.

“So you’re really talking about people who are earning strong salaries and have a lot of discretionary income.

“If they only have a spare couple of hundred dollars per month, and you’re relying on the dividends to meet the ongoing expenses, you’re not taking into accommodation some of the potential [risk factors].”

Potential impacts on cash flow include: loss of employment; changes in income levels; and movements in interest rates.

In the current environment, changes to employment status and income levels are key concerns.

And while some clients may believe they have enough discretionary income to employ such a strategy, Biviano said advisers must undertake thorough cash flow analysis to ensure this is the case.

“Not many clients that I’ve ever dealt with have a good handle on where their money is coming from or where the money’s going,” Biviano said.

Having insurance in place is also a must, Biviano said, including income protection, life insurance and potentially total and permanent disablement insurance and trauma.

Red herrings

Clients in the wealth accumulation stage — who often have long investment time horizons and potentially higher levels of discretionary income — are often framed as perfect margin lending candidates. But certain changes taking place in their lives may affect their candidacy for this strategy, Biviano said.

“It’s nice to say wealth accumulators are good for gearing, but wealth accumulators are also those people that are going through life-changing events, such as getting married or having a family, and potentially that means they may be dropping down to one income.”

Other people in this stage of life may take time off work to travel or even work overseas, and so may not be earning an income for a period.

These issues can impact significantly on a client’s ability to meet interest repayments and as such must be explored by the adviser, Biviano said.

Other strategies

Ipac technical services manager James Proctor believes planners may sometimes overlook other strategies that could provide a similar outcome to gearing.

He believes an adviser’s first step should be to ascertain whether the client can reach their goals without using any form of gearing.

“And if the answer to that is ‘Yes’, then you don’t recommend gearing,” Proctor said.

As Proctor pointed out, there may be other areas of the portfolio that can be optimised to achieve a similar result.

For example, a client may have a 50-50 asset allocation for growth and defensive assets within their superannuation fund, he said. If a client’s asset allocation within their super fund is fairly conservative, but they are prepared to indulge in a very aggressive strategy, there is clearly a mismatch.

“An alternative would be to take your super fund up to 100 per cent growth assets before you even think about gearing,” Proctor said.

A planner may be able to restructure a client’s portfolio in a way that increases the overall return, rather than having one particular portfolio with an aggressive strategy.

Biviano said that when using balanced managed funds, some planners may not realise that they are inadvertently gearing clients into cash and fixed income investments, rather than growth investments.

Biviano recommends using sector specific funds rather than balanced funds or similar when gearing a client, due to the higher cash and fixed interest components of in balanced funds.

“Then you’ve got people gearing into cash and fixed interest and that becomes questionable,” Biviano said.

As part of a client’s overall portfolio, a planner may wish to advise clients to use Australian share funds for margin lending, but invest in cash and term deposits separately.

But there may be situations where being exposed to cash and fixed interest may be useful — for example, for managing volatility, Biviano said.

Where a client is close to margin call and they do not have sufficient funds to meet that margin call, it may be possible to reduce the volatility by moving from a sector specific fund into a more balanced fund.

“So you’re not longer invested 100 per cent in shares and property, you’re now spread about 10 to 20 per cent in cash, and then you’re doing it mainly just to manage the investment volatility.”

Gearing options

If a client does require a geared strategy to meet their goals, margin loans aren’t the only potential answer.

“Margin lending is one way of obtaining extra funds to gain that exposure, but there are other options,” Biviano said.

Other options include a line of credit secured against the home or another type of property, or internally geared share funds, Biviano said. The latter represents a lower level of risk from a client’s perspective in terms of cash flow and liquidity requirements.

Dale agreed that “where it’s looking like the market could continue to be volatile for a while, [home equity] is a cheaper and potentially less painful option, because you don’t have to meet margin calls if things go wrong”.

AXA’s Krawitz said, where possible, his group would also “encourage home equity lending [because of the] lower cost”.

“We currently limit that to an LVR of 80 per cent at establishment and ongoing,” Krawitz said.

Investors may also prefer to use internally geared funds or investments such as instalment warrants. Unsecured personal loans are not appropriate because the higher interest rates involved mean investors require a much higher return to break even, Biviano said.

Proctor pointed out that while some clients may be averse to borrowing against their home to get exposure to shares, if push comes to shove, the home will not be out of the margin lender’s reach.

Margin calls

One of the difficulties of margin lending during a period of market volatility is the greater possibility of margin calls.

If you are concerned about the outlook for share markets but believe a margin lending strategy is suitable, it may be wise to only employ a conservative LVR, Dale said.

Many financial planning dealer groups place a cap on the LVRs clients can employ in margin lending strategies.

Doing so protects both the client and the financial planner providing the advice, and prevents events such as the Storm Financial disaster from occurring.

Groups such as Fiducian, Count Financial, AMP Financial Planning and AXA each have LVR limits in place.

Professional Investment Services has recently employed a software solution provided by Midwinter Financial Services to help its planners manage their clients’ margin loan portfolios.

Commonwealth Financial Planning and Financial Wisdom, both Commonwealth Bank of Australia (CBA) owned entities, have maximum LVRs in place of 70 per cent (including credit card and personal debt).

Advisers in these groups must be vetted and trained before being allowed to provide gearing advice, and recommendations including capitalisation of interest and double gearing are not permitted.

Interestingly, in its dealings with external dealer group Storm Financial, CBA allowed clients to have higher LVRs in place, as well as double gearing strategies.

High maintenance strategy

Margin lending in a volatile market, particularly where a client has a high LVR, is not a low maintenance strategy.

“It is an active strategy, it’s not one that you sit back and not worry about with the client,” Biviano said.

Biviano said advisers must monitor the monthly or weekly reports from the lending providers and “decide what your strategy will be if your clients come into the buffer zone”.

“Every planner should consider what the exit strategy is, because you’ve entered into the arrangement, but how are you going to unwind it,” Biviano said.

There are a number of different options when it comes to exiting a margin lending strategy:

• pay out the debt in the margin facility;
• sell the underlying investments; or
• try and maintain the debt until the investment is in a cash flow positive position.

Biviano said while the final option is difficult in a margin lending facility, it’s not impossible.

Another option is for clients to salary sacrifice into superannuation and at retirement use tax-free super funds to repay the loan, allowing the client to receive tax advantages while also maintaining the share portfolio.

However, such a strategy could be exposed to legislative risk, Biviano said.