Margin lending: the state of play

It would be fair to say that the advisory community is in two minds regarding the real returns offered by margin loans. But there is no doubt about the underlying demand among investors for them — an appetite that is being recognised and fuelled by a number of product manufacturers.

Most importantly, after 24 difficult months, with poor profit performance, corporate scandals and the war in Iraq, all driving equity market performance in a downward direction — the factors conducive to gearing are now beginning to align.

Not only are economic fundamentals moving in a more positive direction while interest rates stay on hold, but the suppliers of margin lending products have significantly increased product sophistication and ease of use.

As an investment product class, margin lending is now worth $10.8 billion in Australia and providers have recognised its key attraction — that Australians are comfortable, perhaps even pre-conditioned, toward borrowing money in order to build wealth.

And this is despite the credit crunch that many margin lending customers underwent in 2002, when margin call numbers rose 66 per cent compared to the previous 12-month period.

Even with this credit squeeze, numbers of margin lending accounts actually increased slightly in the final quarter of 2002, and can be expected to grow further if the Wall Street gurus are right in their predictions for a sustained market improvement.

Market analyst Cannex has recently spent six months conducting intensive research into margin loans — assessing the market offerings available and the underlying trends.

Cannex director of research Kathlene Jones says: “It is clear from our research that uptake of the margin lending products continues to grow — probably quite closely related to theAustralian Taxation Office(ATO) ruling allowing related tax deductions.”

Jones says the product manufacturers, after a lull during mid-to-late 2002, when price competition appears to have reached its viable limits, have moved into 2003 with a strong drive toward providing value-add services as a means of product differentiation.

This drive for better efficiency and effectiveness of the products for both advisory and direct investment channels is spawning products that Jones says are much closer to portfolio platform tools and retail credit products, respectively, in their ease of understanding and usage.

Additional features include:

* making the products available and accessible online;

* providing calculators and simulators, so new consumers can test the likely investment experience; and

* the ability to trade options as strategies to reduce the investment risk.

Key players driving this trend have been BT and St George, which, according to Jones, are “the innovators and offer the widest range of product features”.

Questioned on the underlying strength of demand for this product type, Jones says: “I think there is a generation of investors there that are more than happy to live with the increased risk.”

Additionally, Jones believes some significant market appetite is coming from investors looking for an intermediate form of leveraged investment that will allow them to grow their wealth more rapidly but which requires less upfront capital than investing in a home.

However, Paul Resnik, from the Paul Resnik Consulting Group, questions the validity of margin lending products given the marginal net return before tax, when compared to the risk involved.

“If you were going to ask me to do it, I wouldn’t (in the current market) … but I don’t want to talk people out of investing in these products … I would simply say that people need to be properly informed of the investment and the risk.”

He says that margin lending products, along with all other investment alternatives, simply need to be considered in respect of a client’s risk appetite and investment goals.

That said, he does believe that: “Margin lending overall, like any geared investment, is better for long-term aggressive investors not approaching retirement.

“These products have a poor recent history but there is now a better outlook. Anticipation that stock returns will be seven to nine per cent this decade.”

The challenge, he says, is that margin loan rates start at six per cent. “This does not leave much exposure to growth. This is important, as your starting point for gearing is to look at what the risk premium (of a given geared investment) is over and above cash.”

The other important factor he outlines is the inherent contradiction between the recommended approach of taking a long-term investment horizon, but then trying to find margin lending investments that will outperform in order to justify the gearing approach.

“All the studies I have show fairly clearly that a given fund manager will outperform no more than one time in 10.”

The pressure will be that on the one hand, aggressive clients, still hoping to access the absolute return levels as during the late 90s, may see heavy gearing as a means of achieving those returns through quantity of investment rather than quality.

On the other hand, financial advisers will need to practice caution in assessing the underlying debt-servicing capabilities of the investor, particularly given the possibility of more margin calls should the predicted rally fail to materialise.

Margin lending: an opportunity

For any adviser considering directing clients into margin lending, the prospects are now beginning to shift to the positive, following 12 tough months.

Importantly, with the war in Iraq now past, macro-environmental factors appear to be looking up:

* expectation of a general equity market upturn in the final six months of 2003;

* interest rates likely to remain in a holding pattern as regulators, both internationally and at home, seek to protect fragile economic performance worldwide;

* recent revisions of Australian Taxation Office (ATO) rulings have made capital protected margin loans a more attractive investment after tax.

If the market expectations materialise, then now may prove the right time to move clients into a leveraged position to enjoy increased investment returns and stable capital costs.

And there is certainly plenty of products being made available, as the current product manufacturers seek to exploit the continuing steady growth in demand, both through advisory and direct investment channels.

However, the acid test remains whether margin lending provides rewards commensurate with the increased risk it represents.

The current average rate for a margin loan is approximately seven per cent, while the consensus is for share market returns averaging seven to nine per cent for the remainder of this decade.

The result before tax is a fairly marginal one to two per cent return, based on these average figures.

The net outlook: the environment and the product supply competition is conducive to increased margin lending activity. The question that remains to be answered is determining which clients have the appetite for and capacity to live with what is clearly a relatively higher risk investment product.

Factors such as the likelihood of steady interest rates should lessen fears of margin calls - but nonetheless, advisers will need to pay careful attention to both product price and features, and also seek outperformance by the underlying stocks or funds, to provide return commensurate to the risks involved.