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Learn how to build a successful geared portfolio that withstands market volatility.

Photo of Julie McKay By Julie McKay, Leveraged Equities

Legislation that clarified the regulation of margin loans was passed by the Federal Government at the end of 2009. One key change was that margin lenders must notify the borrower when a margin call occurs. Reputable margin lenders already took agreed steps to do so, but the legislation ensures that all providers will adopt a notification process by January 2011.

Investors are still apprehensive about margin calls: they appear to be unpredictable, must be remedied in a short time, often coincide with falls in other investment values, and may force action that is contrary to the investor's long-term strategy. A little planning can go a long way to reducing these concerns.

A margin call occurs when the amount you have borrowed goes above a level that is acceptable to the lender. Borrowing levels are assessed relative to the value of the underlying investment portfolio. Assume two investors have borrowed $1000 each. Investor A has an investment portfolio worth $2000 and Investor B has a portfolio worth $1100. Their gearing ratios are 50 per cent ($1000 divided by $2000) and 91 per cent ($1000 divided by $1100) respectively. Notice that as the value of the investment portfolio falls, the gearing ratio increases.

In this article we refer to the lender's acceptable borrowing level as the loan-to-value ratio (LVR). If the lender's LVR is 75 per cent, the investor's gearing ratio can reach 75 per cent before triggering a margin call (we will explain the buffer later). In our simplified example, Investor B, with a gearing ratio of 91 per cent, will experience a margin call while Investor A remains well below acceptable levels.

The fall in Investor A's portfolio value that would have to occur before triggering a margin call is a function of the lender's LVR and the investor's gearing ratio. Given a loan amount of $1000, the minimum portfolio value acceptable to the lender is $1333 ($1000 divided by the 75 per cent LVR). A fall from $2000 to $1333 represents a fall of 33 per cent of the current portfolio value.

If, instead, the LVR was 55 per cent, the portfolio could withstand a fall of only 9 per cent before triggering a margin call. Notice that the closer the investor's gearing ratio is to the lender's LVR, the lower the fall in value the portfolio can withstand before a margin call is triggered.

Portfolio characteristics play a role

Assuming the amount borrowed remains constant, determining the likelihood of a margin call occurring means assessing the likelihood of the investment portfolio incurring the types of declines in value outlined above. The likelihood of a margin call is therefore closely tied to the characteristics of your investment portfolio.

Compare two investors both with a gearing ratio of 60 per cent against an LVR of 75 per cent. Both portfolios can withstand a decline of 20 per cent before triggering a margin call. Investor A has an underlying investment portfolio that is diversified with a value that moves within a narrow band around its overall price trend. Investor B's portfolio comprises a single share with a price that moves within a wide band on a daily basis. The portfolios may match each investor's individual financial objectives and expectations, but Investor B has a higher probability of experiencing a margin call.

In summary, the likelihood of a margin call is a function of how close your gearing ratio is to the lender's LVR and the degree by which the value of your portfolio fluctuates on a day. The examples so far assumed that the amount borrowed remains constant. Keep in mind that your gearing ratio can also increase if you increase the amount borrowed, for example if you capitalise interest to the margin loan facility.

Applying a buffer

If you borrow at the maximum LVR allowed by the margin lender (in other words, your gearing ratio equals the LVR) then even a small decline in portfolio value will trigger a margin call.

To avoid triggering a margin call for small market moves, margin lenders apply a buffer of between 5 and 10 per cent when determining if a margin call has occurred. Using the example of a $1000 loan, a 50 per cent gearing ratio, 75 per cent LVR and 10 per cent buffer, the minimum portfolio value acceptable to the lender will be $1176 ($1000 divided by 85 per cent being the LVR plus buffer). Continuing our example above, a fall from $2000 to $1176 represents a fall of 41 per cent. Compare this to the 33 per cent fall in the example without buffer.

If your margin loan provider offers a 5 per cent buffer, the margin calls may be more frequent but the amount needed to reduce your gearing ratio will generally be less than a margin loan offering a 10 per cent buffer. One important lesson about the buffer is that it does not represent additional borrowing capacity. Once a margin call is triggered, you will usually be required to reduce your gearing ratio to a level no greater than the lender's LVR, not the lender's LVR plus buffer.

If the margin loan for Investor 2 offers a 10 per cent buffer, they might think they can reduce their loan to $935 ($1100 portfolio multiplied by 75 per cent LVR plus 10 per cent buffer). But they will receive a margin call for $175 to reduce their loan to $825, a 75 per cent gearing ratio.

Expectations an important factor

An investor's gearing decision should be based on their expectations about their investment portfolio, their financial objectives and their risk appetite. Deciding to minimise or manage a margin call is an outcome of that broader investment decision. Assume an investor expects the market to trend upward strongly but with daily fluctuations, and decides to borrow up to the maximum amount allowed by the lender. This investor will need a strategy for managing a margin call, given the higher likelihood of it occurring.

For example, an investor could maintain other liquid assets that could be used to satisfy a margin call if it occurs. Compare this to an investor with fewer liquid assets or who prefers not to sell their underlying investment portfolio. They may decide a margin call is too great a risk in their circumstances and decide to lower their gearing ratio.

Let us accept the unorthodox view that a margin call is no more evil than a stop-loss order. A margin call imposes discipline at a time when investors need to make dispassionate decisions. But it should be the last bulwark. It is sensible to develop a strategy for managing a margin call or minimise its likelihood by reducing gearing levels or diversifying your portfolio.

The new regulations should give investors some comfort by imposing consistent standards across the industry. But the best strategy continues to be regular monitoring of your portfolio and taking action before a margin call occurs.

About the author

Julie McKay is Head of Wealth Products at Leveraged Equities.

From ASX

ASX has commissioned several tax papers that update investors on important taxation developments for various ASX Listed products. The papers were written by Alison Noble, account director, and Patrick Broughan, Principal, of Deloitte. They include:

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