A leveraged leap of faith

Margin loans have long been associated in the popular minds with instability in security markets, and the potential for margin lending to exacerbate the amplitude of cycles in stock prices has received considerable attention in the years since the crash of l929.

Today, financial planners are chasing this new arena of investing as a part of investor wealth creation. According to the Reserve Bank of Australia (RBA), the value of margin loans has risen above $26 billion, following five years of compounded growth of about 35 per cent.

Eric Blewitt, Adelaide Bank’s head of margin lending, said “gearing has a place in a wealth generation strategy”.

A research report conducted by Sydney-based Investment Trends found that 42 per cent of planners said the reason a planner recommends margin lending to a client is because of client demand.

Blewitt agrees. He said his firm found the interest in margin lending was largely driven by client demand and, “the client has asked for it”.

He added, “the planner is not doing a client justice if margin lending does not come into the discussion” when assessing investment selection options.

Declining margin calls

The reduction of fear has played a role in the increasing popularity and demand for margin loans.

For example, Blewitt said earlier this year on February 28, the All Ords dropped by 161 points (to level at 5,816).

He said “even on such a significant drop in the market, only 12 Leveraged Equities’ clients (Leveraged Equities is a wholly owned subsidiary of Adelaide Bank) received margin calls”.

The RBA has released recent numbers that indicate the average size of a margin loan in Australia is around $160,000.

However at the very top end, loans exceeding $10 million are not unusual.

According to Blewitt, this is an indication of the current market’s expansion. RBA figures show these types of loans have increased from 5 per cent of the market to 14 per cent over the past two years.

Investing with leverage has rapidly transformed into a ‘state of the art’ concept among margin lenders and financial planners when it comes to wealth creation.

The notion of ‘have debt, make money’ seems to be breeding an inherent, endogenous money supply from a surge in margin lending activity that, according to the numbers, has boosted share investment returns and raised investor portfolio valuations. Interest rate movements need not apply. Investor emotions are easing, having less of an impact on investment decisions.

Interest rates

Changing demographics and investor education have placed a positive emphasis on the ‘bull’ and minimised the ‘bear’, even in the face of unpredictable interest rate moves.

Consumer and investor education has reduced the ‘noise’ and is now facilitating an exponential growth in the margin lending arena.

While the RBA’s recent decision to keep the official cash rate at 6.25 per cent, Australian interest rates are still higher than those in major developed countries, even above rates in the United States, where they remain steady at 5.25 per cent, leaving some economists divided over whether or not the RBA’s board will raise rates at its next meeting in May.

But market mavens also remain equally bullish across the Pacific where, according to recent Bloomberg financial reports, the US Federal Reserve is unlikely to cut interest rates soon, despite the slowing pace of economic growth (its preferred measure of inflation, which showed price pressures rose faster than expected in February).

The recent RBA figures have broken down the $26 billion Australian margin lending market to represent approximately 161,763 margin lending accounts (including protected loans) and over 4,727 new accounts.

Of this year-to-date increase (as of results for the quarter-period ended December 2006, over the quarter ended September 2006), where the margin lending market was then at $1.872 billion, the average margin loan balance increased to $173,026 (an increase of $6,710).

The statistics show planners, as well as clients and investors, are targeting an entire arsenal of tools to achieve the wealth effect, and margin lending is very much at the top of their tool box.

A report by the Investment and Financial Services Association found borrowing to invest makes sense once it is understood how investment returns will exceed the cost of borrowing.

As planners and clients are equally becoming more educated and familiar with the margin lending concept, from the administration and implementation of the loan to understanding the tax benefits, the popularity of the product itself increases.

Blewitt said: “It’s easy and dangerous to get caught up in one’s own industry, but in reality, planners who do recommend margin lending do it for one reason, and that is to enable the more expedient creation of wealth.”

“At the end of it, there needs to be an end objective of creating wealth, or enabling funds to create that creation,” he added.

Financial planners know the two most popular ways of leveraging exposure to direct equities is through margin lending and instalments, because both products offer the benefits of capital appreciation and an income stream through dividends and franking credits, as well as being entitled to interest deductions.

Nick Renton, former fellow of the Securities Institute of Australia, was quoted as saying: “Negative gearing is, of course, never really negative — borrowings are always a positive amount of total assets.”

With the share market reaching new highs, leverage can serve as an important tool to enhancing the performance of investment portfolios.

Blewitt said his firm has seen a profound increase in investors asking their planners about margin lending.

He supports the notion that a number of planning firms say their planners are being ‘schooled’ to also raise margin lending with their clients as an additional investment vehicle when discussing wealth creation.

Another survey conducted by Investment Trends found brokers reported that their use of gearing is increasing, driven by an increase in product education and understanding of how margin lending can benefit an investor’s portfolio.

Gearing alternatives

The Investment Trends survey highlighted that four in five advisers (79 per cent) said they provided advice to clients on gearing (options), while among those who advised on gearing, three quarters (76 per cent) said margin lending was their most commonly used gearing tool.

The various forms of gearing were broken down by category and popularity (see table).

Does stock market volatility have a say anymore?

According to a report on margin lending and stock market volatility prepared by senior economist David Fortune at the US Federal Reserve Bank of Boston, “The mechanism by which margin loans are popularly believed to increase stock price variability was described as ‘pyramiding and anti-pyramiding’ because security credit is cheaper than the cost of investors equity”.

In other words, in theory, having access to brokers’ loans stimulates the demand for stocks, inducing price increases that provide the additional equity that is the foundation of further borrowing to finance additional stock purchases.

The RBA’s recent decision to keep interest rates on hold may have sent the dollar into temporary free-fall, but the share market nevertheless sailed higher, climbing 83.8 points, or nearly 1.5 per cent to finish the day setting a new high at 6,097.

Investment Trend’s survey found that the proportion of advisers who do not recommend margin lending because they believe it is too risky fell to 4 per cent in 2006 from 15 per cent in 2005.

The study also found the possibility of margin calls as a barrier to recommendation also fell to 28 per cent from almost 40 per cent a year earlier.

In its report, the RBA found the average number of margin calls in 2006 had fallen each day to a record low of between 0.28 and 0.57 calls for every 1,000 client accounts.

Compared against March 2003 findings, where the average number of daily margin calls was 6.01 for every 1,000 client accounts, reflecting a 93 per cent drop over the three-year period in the averaged number of daily margin calls.

Blewitt said the buoyant share market has made margin lending an important part of any investment strategy.

“Margin lending has become popular for people who want to build a portfolio or have an income from investments. Quite simply, a margin loan is an enabler to increase your opportunity to create wealth and meet an investor’s objectives,” he said.

Importance of margin lending as a wealth generator

In the past, advisers and investors thought of margin lending as a tool reserved for use by high-net-worth individuals. New products and improving awareness is now widening its range of accessibility.

From a planner’s perspective, margin lending is viewed as another way to access another part of a client base.

“Most of the world’s wealth is created through borrowings, be it corporations or a business looking to grow. Entities looking to grow capital have typically borrowed to do so. The same principle applies to individuals who gear to generate wealth,” Blewitt said.

Over the past several years, planners have focused on lump sum investments and superannuation. While still an integral part of many advisers’ businesses, planners are now turning their attentions to wealth creation, and gearing is becoming a part of that.Consumers are initiating their wealth generation strategies earlier and are less worried about achieving greater returns within a short-term investment period.

The informed investor is now showing signs of understanding what is more realistic in order to average better returns is longer-term exposure, over-riding what may have been considered in the past to be unrealistic expectations.

There seems to be a greater awareness throughout the marketplace of just how important the element of time plays in overall returns on any portfolio, certainly inclusive of margin lending.

Planners and investors’ increased use of debt to create wealth is fast becoming part of a level playing field.

A number of major players in the game of gearing are making it easier for investors to not only get started, but to help thwart preconceived notions that a geared investment was a bad thing and that it is no longer a game only considered for the sophisticated investor.

“Investor education has played a role in the way the investor today views margin lending and gearing to achieve wealth,” St George head of margin lending Andrew Black said.

ANZ experts agree. Their research suggests clients and investors typically think debt is bad.

However, according to John Daley, head of margin lending, ANZ, “On the contrary, if geared, you’ll see a higher return than if not geared”.

Daley said it is crucial for planners to say as much to their clients to remove that ‘emotional incumbent’ on the customer.

Planners are encouraged to talk to their clients and ward off the perceptions and tales that fuel an investor’s fears.

So, in the interest rate we’re currently at, Blewitt said, “while we have a high interest rate environment right now, with the average cost of borrowing at about 9 per cent to 9.25 per cent, the highest tax payer will be able to claim the interest as a tax deduction, and after the cost of the interest rate, the real cost of borrowing is around 5 per cent”.

That, said Blewitt, makes it attractive because, with the deductions and appreciation in capital, overall capital growth is upwards.

Why it makes sense to leverage

Financial planning professionals say many consumers today use gearing to reach a specific goal; they see the use of instalment gearing commonly earmarked for a specific purpose, such as saving for a deposit on a home.

While that doesn’t necessarily fit the traditional definition of a margin loan borrower, nor does the once used profile of a high-net-worth individual.

Today, they’re younger, savvier, less conservative and thus more willing to assume a bit more risk and typically have a longer time-horizon on their side.

They are cautious, but seem to have also figured out the merits of leveraging in order to accumulate wealth.

Still, ANZ experts tell us that the vast majority of customers are not borrowing as much as they’re allowed to.

ANZ said the average customer only borrows about 50 per cent, but is allowed to borrow up to 70 per cent, according to the RBA figures.

Daley said he believes one of the reasons for this is simply to “leave themselves a larger buffer by putting less at risk should an investor be forced to sell on a dip in the portfolio”.

“The dip would have to be pretty substantial, around 20 to 25 per cent of a drop in the portfolio’s value,” he said.

With the market experiencing a really bad day with a drop of about 5 per cent, that still isn’t enough to impact a portfolio on margin (note: other factors would have to be on solid ground, such as the size of a portfolio and the strength of the underlying securities).

Both Adelaide Bank and ANZ said they are seeing instalment gearing used to build up a portfolio over time. Blewitt said “the assets that the margin lenders are prepared to take as security remains a differentiator”.

ANZ has a launched a product called the diversified margin loan, which allows them more security value and provides for the ability to withstand bigger drops in an investor’s portfolio by as much as 25 per cent (note: the security it provides also depends on the overall composition of a client’s portfolio).

As the diversity of uses grows, advisers and clients’ requirements from their margin loan change with it.

With about 20 lenders in the industry, differentiation based on loan-to-value ratios (LVR), interest rates and the number of approved securities are no longer the only key differentiators when deciding which lender to work with.

Investor awareness, a rise in a better understanding of the mechanisms as influenced by an even greater understanding of basic global economic activity, has provided a motivator effect among consumers to get in on the action.

They’re starting younger, thereby affording themselves the benefits associated with being invested over a longer period of time, and the accumulation of wealth generated by the capital appreciation owed to that time.

Investor demand

Client ease with easy borrowing capacity and higher loan-to-value ratios were found to be key among the differentiators that influence a client or investor transitioning into margin lending activity.

While the proportion of the underlying asset that a lender will lend against can be a differentiator when deciding to invest on margin then deciding which lender to work with, ANZ’s research supported the consensus that most margin account holders do not borrow up to their maximum capacity.

The majority of investors were found to choose more conservative gearing ratios.

From a planner perspective, the ease of transitioning a client from other existing products still faces resistance.

St George’s margin lending group found that education plays an important part in transitioning.

Black said that if the planner is well-versed on the product, it can then be better ‘sold’ in a way understood to the client or investor. (For more details, turn to page 31).

ANZ’s research suggests that advisers want assistance from the margin lender in explaining gearing concepts and products to the client in clear and simple language. ANZ has responded to this by committing the past 12 months to revising its brochures.

An Investment Trends survey found 45 per cent of advisers surveyed said there were “procedural barriers” that precluded clients’ use of margin lending, beginning with the lack of client understanding.

But 15 per cent of planners surveyed said margin lending was “too hard to explain to clients” and 5 per cent said it was “too risky for the adviser”.

The survey also found that 17 per cent were worried about the state of the equities market, while only 3 per cent cited lack of support from their relationship manager as a barrier to further use of margin lending.

Notwithstanding, the survey concluded overall that in order to increase client interest and demand, simplicity and flexibility were paramount.

Advisers also want simplicity. The ANZ research found that advisers are looking for a margin lender that is easy to deal with and that has sound back-office processes.

Prompt processing of loan applications, accuracy and communication trailed closely to ease and simplicity.

ANZ has reorganised its call centre so planners can ring up and speak to the same person each time, making it a lot easier to ‘pick up where left off’ from the last conversation during the loan process.

Other lenders, such as St George Margin Lending and Suncorp, are working on similar developments, but it is still an area of the industry that needs improvement.

Product innovation

Private traders are currently experiencing a wealth of financial products that until recently have only been available to investment banks.

Recently, there has been an explosion in online trading, derivatives trading, superannuation funds and the ability of the private investor to access markets that, until a few years ago, could only be invested in by paying hugely inflated commission rates.Planners are also finding new ways to use margin lending, and the marketplace, while yet unsaturated, is becoming aligned with product innovation.

Of the numerous financial products available, leveraging has assumed two homes, one in margin lending and the other beginning to make noise in the leverage market is contracts for difference, also commonly known as CFDs.

Cube Financial Group advises on the trading of CFDs, and said it is an innovative product that provides a client with a high degree of leverage.

Contracts enable a user to outlay a relatively small investment amount to secure an exposure to the underlying share and trade at prices that mirror their underlying instrument. The top 200 shares listed on the Australian Stock Exchange are available for trade as CFDs.

Like margin lending, CFDs are not suited to every investor.

When they do suit is when individuals are aware of the risks associated with all types of gearing and, when profiled by their planners, are determined to have appropriate levels of disposable income and thus the ability to meet margin calls.

Unlike their cousin, margin lending, CFDs are best suited to the sophisticated investor, individuals that have a well-developed understanding of the stock market and have considerable investment experience.

Whereas with margin lending, Daley said, “Customer feedback tells them that at first many investors feel that margin loans are something for day traders”, rather than for an investor with a longer time horizon in mind.

Most lenders agree that, based on customer feedback, they also say that once a customer establishes a margin loan and receives their first account statement and can see the numbers working for them, they find it is much easier to understand and then can start to relax. It’s a matter of the customer using, understanding, and seeing evidence of appreciation in their capital.

“Then the customer begins to see that it’s not that complicated after all,” Daley said.

Both margin lending and CFDs are susceptible to margin calls if the investment decreases in value beyond a certain point.

Trade-off between loan cost and share growth — where the lender fits in

Margin lenders typically target their products and services more heavily towards one channel or another depending on their business strengths, although most lenders offer loans through other distribution channels.

The lender’s focus determines the services and products it prioritises.

ANZ for instance said it focuses on all channels, but its client base is largely skewed towards direct clients.

“As a bank with a large retail base, we will always have a relatively higher share of the direct market, but financial planners remain important to us,” Daley said.

While managed funds, unlisted property trusts and direct equities have assumed a ‘mainstay presence’ in the leverage playing field, some lenders are beginning to offer margin loans against structured products.

BT Margin Lending has recently approved JP Morgan’s new launch, Alternative Energy Strategic Asset Securities.

St George, like many of these players, has an approved lending list that borrowers are allowed to margin against.

And while the list varies from provider to provider, whether it be into direct equities or managed funds, lenders typically lend up to around 70 per cent.

The quality of the underlying security drives the lending values that a lender will attribute to.

Borrowers can also access ‘investment loans’, a capital guaranteed structured product (and part of the overall $26 billion of margin lending in Australia) with up to 100 per cent of loan value available.

These are typically unlisted products and as such, are valued regularly, weekly or monthly so as to maintain a market pulse on the value of the underlying asset.

For instance, Adelaide Bank manufactures a structured product called the Protective Global Opportunity Fund, which is rated by either Moody’s or Standard & Poor’s.

In this case, the bank will hold the investment as collateral for the duration of the loan, with the obligation to the borrower to maintain regular interest payments.

The lending facility will loan against the product that may be prescribed by an investment bank such as JP Morgan or Credit Suisse.

The Australian Taxation Office scrutinises structured products more closely as to see to what extent the investment loan is part of a wider portfolio than may be claimed from tax relief.

Planners increasingly have more options available to them, facilitated by collaborative efforts between product producers and the lending facilities.

Making margin lending user friendly has played an instrumental role in helping customers to separate out their rational and irrational fears.

At the end of the loan period, when the loan is repaid, if the underlying asset has performed well, the value would (presumably) have grown, and the additional proceeds from capital appreciation leaves the client with a positive gain.

“Simply thinking that all debt is bad is not a rational belief,” Daley said.

Stephanie Banks is a business and finance journalist with Wall Street Communications, a corporate communications agency. She was formerly a stockbroker with the Boston branch of UBS Warburg.