This article appeared in the February 2014 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
By Julie McKay, Leveraged Equities
Latest statistics from the RBA show a continuing decline in margin lending, evident in loan amount, number of accounts and loan-to-security value ratio (the level of gearing). This leads to speculation about the future of margin lending.
Reductions in discretionary spending, acceleration of home loan repayments and weak global sharemarkets clearly explained initial margin lending declines after 2009.
In today's environment of low interest rates and with the Australian sharemarket growing by close to 20 per cent over 2013 (based on the S&P/ASX 200 Accumulation Index, which includes reinvestment of pre-tax dividends) further falls in margin lending appear counter-intuitive.
After the GFC there was plenty of talk about deleveraging - households doing everything possible to reduce debt. But significant deleveraging does not appear to be an ongoing reality in Australia. Based on RBA statistics published in January this year, household debt is not showing the meteoric rise of the past 20 years and is yet to return to previous highs. But household debt certainly is not declining similar to margin lending.
Compare the Australian experience with the US; although margin lending markets are different but for these purposes a comparison is reasonable. In the US, margin lending as a percentage of market capitalisation is edging toward 2 per cent, which is slightly above average. Margin lending in Australia reached a peak of 3.5 per cent just before the GFC and has since fallen to around 1 per cent of market capitalisation, well below average. Talk about a roller-coaster!
All this points to a more fundamental shift in investors' use of margin loans.
Reasons given for decline
A cursory review of articles about margin lending highlights a few key reasons people give for not using a margin loan: the strategy is not required anymore; I can get similar returns without taking the risks of gearing; gearing is too risky in an uncertain market; I can draw down on my home loan.
Let us distinguish between "gearing" as a strategy (in the sense of getting exposure to an asset with a smaller amount of capital than would be required to buy the asset outright) and a margin loan, which is a financial product for implementing a gearing strategy. There are many ways to implement a gearing strategy.
Gearing Australian shares can be done through warrants, contracts for difference (CFD) or options listed on the Australian Securities Exchange for example. These financial products have their own risks and benefits but are typically only used by sophisticated investors. Three of the four arguments mentioned above concern gearing as an investment strategy.
'No longer required'
The first argument is that a gearing strategy is no longer required. For people without a steady, non-market related income (such as someone retiring from paid employment) reducing market exposure is absolutely a rational strategy.
Many post-retirement portfolios need some proportion of growth assets to offset inflation, but gearing is unlikely to be prudent, given the investor's significantly reduced ability to recover capital if there is a sharemarket correction. However, many people with 10 years or more until retirement may be underestimating the realities of saving for retirement.
Longevity is a common theme in many financial newspapers today. The general gist is that many Australians will need to fund a longer-than-expected retirement period (or retire later than expected) because they will live longer. Generally, this means starting retirement with a larger capital base.
Saving alone, even in the tax-advantageous super environment, may not be sufficient to accumulate the necessary capital. For many people to reach their retirement dreams (as well as other major dreams such as home ownership), savings may need to earn annual percentage returns in the low teens. Over the long term, these returns may only be achievable with some prudent gearing. In other words, some higher level of risk, by borrowing to invest.
Other ways to get returns
The argument of being able to get similar investment returns without taking the risks of gearing is almost too naive. These investors may need to revise standard capital market theory. There almost certainly will be portfolios offering a similar return to a geared equity portfolio, but no return comes without risk, and financial markets eventually equate the prices of assets that have similar risks. Investors may be able to pick an asset that is under or over priced today but few can consistently pick mispriced financial investments over the long term.
The argument that gearing is "too risky over the short term" basically states an inherent element of all gearing strategies. To achieve a positive geared outcome means total investment returns must overcome the costs of gearing (as well as tax and fees). Options, CFDs and some warrants are typically cheaper ways to implement a short-term market view.
But most geared portfolios need time to generate sufficient returns and that means a long-term investment horizon. Further, an investment strategy, whether geared or ungeared, must be based on a view of the market relative to the financial goals driving the investment. If you don't think the markets will make sufficient returns over your investment timeframe, then not gearing (and possibly not investing at all) is a rational strategy.
Home loan or margin loan?
The final argument focuses on the best way to implement a gearing strategy. This article focuses only on borrowing to invest, rather than other gearing products such as options.
Using residential home equity to invest in shares in a post-Storm financial environment (or considering the post-Future of Financial Advice reforms) is startling!
This article does not cover the potential difficulties that might arise in maintaining the tax deductibility of interest on the proportion of a home loan used to acquire investments. Suffice to say that the Australian Taxation Office takes a dim view of reducing the non-deductible portion in preference to the deductible portion of a loan facility.
In the chapter on the collapse of Storm Financial, the 2009 parliamentary inquiry into financial products and services found the risk of losing the family home was strongly underestimated. The collateral for a home loan is the home itself, not the shares acquired with excess home equity. This means the lender has rights to repossess the home if the borrower fails to meet their obligations. A margin loan is full recourse (meaning a borrower must eventually repay the loan in full) but the margin lender only has rights to sell the collateral shares.
Margin call: a valuable service
A number of articles also mention the "risk" of a margin call and how using home equity "avoids" that risk. The authors or their sources may need to revisit the basic principles of investing. Successful investors have an investment plan that includes an exit strategy. Such a strategy is even more essential when gearing; small market moves (both up and down) are magnified by gearing.
On the basis that any sensible gearing strategy includes moderate gearing over a diversified portfolio, the risk really being considered is that of a significant market correction. Everyone invested in the market is exposed to that risk. A margin call is a last-resort exit strategy, not a risk. The parliamentary inquiry found that many Storm Financial clients wished the margin calls had operated correctly - they would have preferred being left with some capital rather than none.
The parliamentary inquiry also recognised that the rate at which market conditions changed during the GFC created a "formidable administrative burden" in making margin calls (among other reasons for the failure). Investors using home equity to implement their gearing strategy need to ask: who is taking on that administrative burden and at what cost?
In that context, a margin loan is not more expensive than a home loan. The portfolio reporting tools and margin call services offered by margin lenders means a margin loan is often the most appropriate financial product for many investors who want to implement a long-term geared equity portfolio strategy.
The decline in margin lending may be an indicator of investor sentiment; some remain unconvinced that expected returns will more than exceed the costs of gearing. In that case, not gearing is an appropriate response to a reasonable market view. If the decline, however, represents a shift into using other borrowing facilities to gear an equity portfolio, then we may have forgotten the lessons from the GFC.
About the author
Julie McKay is Senior Manager Technical and Research, Leveraged Equities.
Using Options for Margin Lending explains how investors can expand the range of investment strategies for their margined shares.
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