The overselling of gearing

I have long been cautious of the growing use of debt and gearing (especially into share markets) in the investment industry and have written about this topic regularly.

More recently, I have suggested that as a result of this downturn, gearing into share markets will once again become the tool of relatively fewer, more sophisticated investors using more conservative gearing levels.

Already, at year-end 2008, the level of margin loans outstanding has fallen by over 44 per cent from its peak of almost $38 billion in December 2007 and the number of accounts has begun to fall. This figure does not include home equity credit loans and some other loans used to finance share investments.

The Storm situation is at the epicentre of this issue, and while the ‘double gearing’ approach it promoted to some clients pushed the concept to obviously dangerous levels, this is the extreme end of a broader financial services industry that has been increasing the use of gearing for some time.

In light of Storm and the market downturn, the key issues facing the industry regarding gearing are:

1. What types and levels of gearing are appropriate for investors, particularly those (mostly financially unsophisticated) clients who seek advice?

2. Have the remuneration structures been a major factor in encouraging the widespread (and excessive) use of gearing, and how might this be addressed by the industry and/or regulators?

In regard to the first issue, the current downturn is highlighting that most clients cannot comfortably handle the risks of a fully invested equity portfolio with no gearing (when it covers a period of a major bear market), let alone that portfolio two or three times geared. One does not need detailed risk profiling to see this.

The actions of clients who are now exiting ‘risky’ assets (some forced through painful margin calls) and investing in the ‘safe haven’ of cash is evidence enough. Indeed, standard risk profiling may well have come up with the wrong answer prior to the bear market.

Further, I believe a case can be made that an investor engaging a financial planner for investment advice is, by the very action of seeking that advice, indicating they are not financially sophisticated enough to properly understand the real risks of gearing and therefore should not be encouraged to enter such an arrangement without at least considerable education (and I mean years not days).

I know this view is controversial but the revulsion we are seeing in relation to gearing of all forms (especially margin lending) is strongly suggesting this is the case.

Remember, even without explicit gearing, most of the component parts of investment portfolios — company shares, listed property trusts, hedge funds, geared share funds, and so on — may already have significant levels of leverage.

Therefore, the appropriate level of explicit gearing into share markets for the vast majority of unsophisticated clients who go to financial planners is probably zero.

However, some planners seem to believe that certain clients with limited financial resources (even if unsophisticated) should gear into markets because that is the only way they can achieve their long-term investment goals. I think these arguments are flawed because:

1. Gearing increases the chance (and size) of losses, even over the long term, because of the interest hurdle (ie, gearing is far from a sure thing even over the long term);

2. It is these more financially stretched clients who are typically the first to be forced to unwind gearing arrangements at the worst time when difficult conditions strike (eg, they lose their job, need funds for other purposes, etc);

3. Emotionally, given their limited knowledge and circumstances, they are likely to become more stressed by adverse market fluctuations than most and may choose to unwind at a poor time, even if not forced to by financial circumstances.

Given these issues, the probability of such clients sticking to a gearing arrangement such that it actually achieves their financial objectives, even in the long term, is low. Is this low probability worth the risk?

Perhaps, if statements like the above three points are included in the disclosure documents for lending products (in contrast to bland and near useless comments like ‘gearing increases risks and returns’), clients might think twice about taking on these arrangements.

So what about gearing levels. The view that 50 per cent loan to valuation ratios (LVRs) on equity market-related gearing is conservative and that levels of 70 per cent, 80 per cent or even as much as 90 per cent are aggressive but acceptable has been shown to be flawed. Many of those geared at 50 per cent have seen their investment equity wiped out or have been required to put up additional funds or security.

In cases of 80 per cent to 90 per cent LVRs, where investors are only required to hold 10 or 20 cents in the dollar equity, this should be referred to as speculation, not investing. In my view, true conservative gearing is closer to a 10 to 30 per cent LVR.

Of course, LVRs need to be looked at differently when it comes to home equity loans. But even excluding the double gearing approach of Storm Financial (and they are probably not alone), one has to ask what level of loan on the property is appropriate, if at all. What is the risk of price falls in the value of the property? How safe is the household income? At the very least, I doubt whether gearing makes much sense while there is still considerable deductible debt outstanding, and the appropriate LVR for equity investments is certainly nowhere near the high levels (typically 60 to 80 per cent) willing to be provided by lenders.

Is gearing really an investment strategy? In the article ‘Outrunning the debt cycle’ from a February 2007 edition of Money Management, I viewed gearing “as an adjunct to an investment strategy, a tool to bolster your ability to back good investment ideas, not an investment strategy in itself”.

Viewed this way, one does not need to commit strongly to either the ‘pro’ or ‘against’ gearing camp from a philosophical perspective. Rather, it brings the decision whether, and how much, to gear down to the investment opportunities available at the time and the risk profile of the particular investor.

The view that aggressive gearing using Australian share index funds will always work, and was appropriate for all clients regardless of tolerance for risk, was obviously flawed to anyone with a sense of long-term market history.

Just because the Australian share market hadn’t had more than a 20 per cent drawdown for 15 years until 2008 didn’t mean a severe 30 to 50 per cent bear market wasn’t inevitable. After all, prior to the 1990s, such as fall had typically happened once or twice a decade and had continued to happen in many overseas markets even within that 15-year period.

Interestingly, a case can be made that gearing into share markets today is much more attractive than it was one to two years ago. Markets have fallen dramatically, long-term valuations are attractive and interest rates are lower.

For those few investors who have the long-term tolerance to handle gearing, now is clearly a better time to get set, or to even add to existing gearing, as long as one remains within tolerable levels. The fact that most geared investors are running in the other direction suggests most were not suited to gearing in the first place.

In regard to the second issue, it is obvious to me that the remuneration arrangements in the industry have been a significant factor encouraging more widespread use of aggressive gearing. They have enabled some people with minimal assets (or perhaps just some home equity) to become profitable clients for commission-based financial planners, as they can be geared up to produce attractive upfront and/or trailing commissions on the larger gross portfolio of shares/managed funds while at the same time producing a trail commission on the loan.

This is why geared clients are likely to become the focal point of the ongoing commission debate and why change is inevitable despite continued protests by the industry. The recently announced Parliamentary Inquiry into Financial Products and Services, prompted by Storm and other debt-related collapses, is likely to highlight issues and recommend some changes in this regard.

In the meantime, much of the industry will continue to hold the line that improved disclosures of conflicts and payment structures is a sufficient response. However, such arguments are becoming tired. It is true there needs to be more requirements for loan providers to ensure customers are suited to the various obligations they have entered into. Steps in this direction have already been taken for margin loan providers by treating them as a financial services product from July 1, 2009. LVRs are also likely to be reduced further over time.

Ultimately though, I suspect improved disclosure and more responsibility on loan providers will not be enough and the Government and regulators will come under increasing pressure to influence the remuneration arrangements when it comes to the use of loan products for investment in equities and other risky assets by financial planners.

One approach might be to ensure that any planner providing objective investment advice to a client is not able to take commissions on any loans used to gear up the portfolio. The decision whether, and how much, leverage to use in the construction of a portfolio would therefore be made on risk profile and investment opportunity issues alone, without the level of leverage directly impacting remuneration.

Of course, some planners will always give appropriate advice regarding leverage whether they are paid by commission or not, but that is not the point. It is the growing perception that advice may be tainted by these potential conflicts, which can be so detrimental to the reputation of the planning industry.

On a related matter, I have always found the argument that clients prefer to pay via commissions highly dubious. After all, how are these, mostly financially unsophisticated clients, who obviously need assistance on their financial affairs, somehow well positioned to intelligently assess and determine that commission is the financially appropriate way to pay for advice? Of course, there are issues with the relative tax deductibility of fees versus commissions, but this is something that can be rectified by governments.

Obviously, this then raises the broader issue of commission on investment products generally, which I do not intend to cover in this article. However, focusing on the commission on loans is probably an appropriate starting point and it may well be one of the key areas of focus for the Parliamentary Inquiry.

The Financial Planning Association’s (FPA’s) initial approach regarding Storm Financial has been to defend gearing as an investment strategy with the argument that clients need to go into these arrangements with their eyes wide open. FPA chief executive Jo-Anne Bloch was also quoted in January as saying, “If you start pointing fingers at Storm and their business model then you’re going to have to start looking at a whole range of others issues, like hedge funds and all sorts of other instruments”.

As I noted in my article last month, some hedge funds, especially fund of hedge funds, clearly disappointed in 2008, but equating their 20 to 30 per cent losses — which might make up perhaps 10 to 20 per cent of a client’s portfolio (an impact of minus 2 to 6 percentage points on a total portfolio) — with the total destruction of wealth and lives that the double leverage model seems to have wreaked on some clients is a very distorted and uneducated comparison.

Indeed, the investment return for a double geared client who started with $350,000 equity in their home and now has no home or other assets while still owing the bank $100,000 on a margin loan is minus 129 per cent (ie, 20 to 60 times worse than the impact of hedge funds in the example above), highlighting the flaws in the above comment. Some seem to have fared much worse.

The FPA approach of providing a blanket defence of gearing as a strategy and trying to turn the spotlight on investment product providers is a disappointing response that is unlikely to bolster much-needed confidence in the planning industry. Most gearing (especially aggressive gearing) is well on the way to going out of favour in the current bear market, despite the better opportunities for sensible gearing that are now emerging. In the meantime, some advisers will rightly be forced to explain (perhaps in court) how some inherently conservative and unsophisticated clients ended up so heavily geared and with such disastrous losses.

The broad reaching implications of this once-in-a-generation financial crisis may provide a legitimate excuse for some of the mistakes and losses that have been made by participants in the investment industry through this very difficult period. However, the overselling of gearing into share markets to unsophisticated clients should not be one of them.

Dominic McCormick is chief investment officer at Select Asset Management.