Unfairly on the margins

Margin lending has become a hot topic during recent months as financial markets fell to levels that qualify as a technical correction (negative 10 per cent) then a bear market (negative 20 per cent). As a result of these falls, the number of margin calls has increased.

At the same time, I have seen margin lending subjected to substantial negative opinion, portrayed as a monster of debt and downfall that leaves companies and investors alike struggling to meet their payments. This has not helped calm investors at a time of uncertainty, and I believe it paints an inaccurate picture of how the investment lending industry operates. It’s therefore an opportune time to reinforce margin lending as a long-term wealth creation strategy that still works during times of market volatility. Now is also the time to revisit the basic rules that should be followed to manage and mitigate one of the key risks, margin calls.

Let’s focus on margin calls first. The reality is that a large market fall does not automatically mean a margin call will occur. In fact, despite the Australian share market falling by almost 11 per cent in January 2008, less than 1 per cent of our margin lending client base received a margin call. This means that over 99 per cent of our clients were able to successfully manage their risk levels and avoid receiving a margin call altogether.

So how did they do it? In general, these clients followed the basic rules of gearing, which is to borrow conservatively and diversify your investment portfolio. To illustrate this, an investor who is geared conservatively at 50 per cent into a range of blue chip securities would need to experience a 35 per cent drop in their portfolio to receive a margin call. While the Australian share market fell by 24 per cent between November 1, 2007, and January 22, 2008, this fall would not have been large enough to cause a conservatively geared client to receive a margin call. Another interesting finding is that of those investors who did receive a margin call last month, many did not have a financial adviser, which I think is a good example of the role professional advice plays in managing risk.

If we look even more closely at investors who had received margin calls since November 2007, a few trends begin to emerge. These can act as a checklist to give your clients if they are using a margin loan.

Generally, clients who experience a margin call have the following characteristics:

> their portfolios are highly geared, close to the maximum level, which is often around 70 per cent or 75 per cent;

> they are holding a concentrated portfolio, sometimes in only one or two shares;

> they are not actively monitoring their portfolio or loan account using online tools; and

> they do not take any pre-emptive action when there is increased market volatility and therefore have to react quickly when the margin call is issued.

Therefore, focusing on managing items like the above can be an effective way of reducing the chance of receiving a margin call.

It is, however, important to put this all into context. This is because in times of turbulent equity markets, margin lending is still a valid and safe way of helping clients to create wealth when it’s used in the right way.

Clients need to be sure of two things though: first, they need to have a strong, positive opinion about the equities or funds they are investing into and should be asking the question, ‘Do I want to invest in this company or fund and does it suit my growth profile?’ If the answer is ‘no’, they should not be investing using their own money or anyone else’s.

However if the answer is ‘yes’, the next decision should be how to fund the investment, with typical options being cash, margin lending, protected loans or drawdown on home equity.

To help make the right funding decision, it is important to keep in mind that margin lending best supports a medium to long-term investment strategy of five years or more.

It is not a get-rich-quick approach and the best results are seen where margin lending is set up in a way that invests through market cycles. This can either be done via an upfront, lump sum investment or the ‘little and often’ approach offered by instalment gearing to give the benefit of dollar cost averaging.

Secondly, investors need to understand the risks of using gearing. Rule number one says that the use of leverage increases risk, but increased risk is not a bad outcome if you understand what it is and how it can be managed.

Combining margin lending with professional financial advice, the right approach to risk management and a good investment portfolio is a tried, true, and well-tested method of creating wealth.

It enables clients to take advantage of the two fundamental building blocks of wealth creation — leverage and compounding. Done in the right way, your clients can have a very positive experience using debt.

Peter van der Westhuyzen is division director at Macquarie Investment Lending.