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Margin call better than losing your home

Photo of Julie Mckay By Julie Mckay

min read

Understand the risks of using home equity to buy shares.

The comment has been made many times: borrowing to invest by drawing on excess home equity is cheaper than a margin loan and safer because there is no margin call. At best, this is naive because it undervalues prudent risk management. It also ignores that large group of young investors who may benefit the most from gearing but don’t own a home or have excess equity.

It is reasonably well understood that the benefits of gearing come with additional risks. But investors who are able to borrow against a home often have reduced ability to recover capital losses. They may be closer to retirement or have a larger savings gap for example.

Borrowing costs are important, but downside management should be the top criteria for such investors. On this measure, not all facilities for borrowing to invest are equal.

Tilt

One reason given by geared investors who shun margin loans is the margin call. First, put the likelihood of a margin call in context. Take an investor who borrows half the amount invested in a diversified, quality portfolio. That portfolio would have to experience a fall of a similar magnitude as the global financial crisis before triggering a margin call.

But, in the context of extraordinary market conditions and for investors with moderate risk tolerance, a margin call can help preserve capital.

Before scoffing at that remark, consider the different rebalancing rules. Rebalancing is deciding whether an asset mix remains appropriate as relative values change over time. Basic rebalancing rules include buy-and-hold, constant-mix and constant proportional portfolio insurance (CPPI).

Whether geared or not, many investors implicitly adopt a buy-and-hold rule – they take no action as the investment mix changes over time. Investors who “buy on the dip” may be following a constant-mix rule.

Take a $100 portfolio invested 60/40 into shares and cash. Assume the shares fall in value, resulting in a 57 per cent shares and 43 per cent cash mix, for example. A constant-mix rule prompts the investor to buy more shares, moving back to the desired 60/40 allocation. Conversely, as share values rise the investor should sell, but this side of the rule is often ignored because of behavioural biases.

Turn

CPPI is the opposite of the constant-mix rule. The investor aims to preserve a “floor” of capital. As the cushion between the portfolio’s value and the investor’s desired floor widens (i.e. the shares rise in value), the investor can afford to take more risk and so buys more shares. Conversely, as the cushion narrows (i.e. the shares fall in value) the investor shifts out of shares back into cash to preserve capital.

The “best” rebalancing strategy depends on what path the market takes. Putting aside tax and transaction costs, when markets move in a slight upward trend, buy-and-hold is usually best. The constant-mix rule tends to outperform when markets chop and change around a relatively flat overall trend. CPPI tends to perform well when markets are rising without too many dramatic dips and reversals.

For gearing to be appropriate and more financially beneficial than other strategies, investors must reasonably expect upward-trending markets with relatively moderate interest rates. In other words, the market conditions that tend to favour CPPI.
More importantly, CPPI equates to buying portfolio insurance. Rebalancing to maintain a floor gives reasonable downside protection (the potential for markets to gap before action can be taken remains) while still benefiting from upward moves. A margin call can be seen as the outer limit of a CPPI rebalancing rule.

There is an art to rebalancing. Most portfolios consist of more than two types of assets. Applying a rule too tightly can result in over-trading, with gains being quickly eroded by transaction costs and tax. Conversely, inadequate or erratic action can mean ineffective portfolio insurance or missed opportunities.

Twist

Investors who borrow by drawing on a home loan understand that the collateral is the home. In contrast, while a margin loan must be repaid in full, the collateral is the underlying portfolio.

If the borrower defaults, the only asset the margin lender can immediately claim and sell is the portfolio. In contrast, the asset the home lender can repossess is the home even if the investments retain value.

This distinction is usually dismissed as a trivial technicality. But this view is underpinned by an unsafe assumption that investments can be quickly sold in all circumstances. Faced with an extreme market correction or a change in circumstances (loss of a job caused by a market crisis, for example), the geared investor expects to sell investments and reduce the home loan, thus eliminating the risk of repossession.

Yet the ability to quickly and efficiently sell some investments can be one of the first casualties of a market crisis. The other causality is credit; lending becomes restricted and banks typically act faster to remedy any defaults, even if that means home repossession.

Even a forced sale of an investment property can have ruinous consequences. It may be possible to sell part of an investment portfolio to remedy a loan default, for example. In contrast, a home lender can only sell the whole property even when the mortgage is only a fraction of the property’s value.

Looking ahead

Successful investing means managing risks. The difference in interest rates between margin loans and home loans reflects the cost of valuable risk management tools for geared investors. Disciplined rebalancing means investors need tools for monitoring gearing levels and efficient ways to settle transactions.

Although unpleasant to contemplate, faced with an extreme market fall, a professionally executed margin call is the outer limit of a rebalancing strategy that may help investors preserve at least some capital.

Investors drawing on a home loan may be able to manually replicate some of the tools and settlement connections that are integral to a margin loan, but at a cost that will almost certainly be significant when, during a crisis, those tools become essential.
 

About the author

Julie McKay is Senior Manager, Technical and Research, Leveraged.

From ASX

ASX-listed instalment warrants are another option for geared investing. To learn about the features, benefits and risks of instalments, take the free online ASX Warrants and Instalments course.

The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.

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