Is it time to start the conversation about a conservative gearing strategy?

Is it time to start the conversation about a conservative gearing strategy?

If you are concerned about low investment returns or building sufficient wealth to meet your future needs, it may be time to consider entering or re-entering the sharemarket through a conservatively geared margin loan.

If you have a conservative risk appetite or are new to investing, you may think that borrowing to invest in shares is not for you. Worries about margin calls or taking big risks may put you off. But there is a way to borrow to invest while still taking a conservative approach.

Appropriate borrowing with a margin loan

The great thing about a margin loan is that you have the flexibility to choose your level of borrowing so you can find a level that is appropriate to your needs and circumstances. You’ll need to factor in your risk appetite and time horizon, but by choosing an appropriate level of borrowing you can still gain a greater level of investments while managing your exposure to a margin call by limiting the gearing level of your margin loan.

The following example shows that with an appropriately diversified portfolio geared at a conservative 30%, the borrower would have avoided a margin call even through the Global Financial Crisis (GFC). Further to this, 8 years on, they would be well placed to take advantage of any sharemarket upside as the world slowly tries to recover from global fragilities. Of course assumptions do apply to this example and are set out on page 2, and you or your clients also need to ensure that any gearing is matched to the appropriate risk appetite and investment outcomes.

Now may be a good time to buy shares for the long term

Nobody knows where sharemarkets will head in the short term, but a period of consolidation is possible as the global economy recovers.

Keeping too much money in cash and avoiding the sharemarket could limit long-term returns, and risk missing an upturn in the market. That is not to suggest that investors should rush into margin lending or any geared product. All too often, investors start a margin loan when markets are rallying – and borrow too much. They receive a painful lesson when markets tumble.

Even worse, investors who borrow too much may get a margin call and be forced to contribute more cash, other collateral, or sell shares in a falling market to restore the loan-to-value (LVR) ratio in their margin loan – the ratio of debt to assets that the lender deems acceptable.

This cycle of investors using margin loans when markets are racing higher, and avoiding them when markets have fallen, damages wealth creation. Margin loans should have a consistent role in your portfolio, and not be used for short-term speculation.

Arguably the best time to start a margin loan is when sharemarkets are consolidating after heavy falls or volatility.

When considering this investment strategy, here are some things to consider:

  • A challenging sharemarket and lower concessional caps on superannuation contributions means investors have to work harder to build wealth.
  • One way to do this is buying shares when they are below long-term trends, in anticipation of a sharemarket recovery in future years.
  • Using a strategy of an appropriately geared margin loan is one way to gain greater exposure to the market and diversify an investor’s portfolio.
  • A conservative gearing approach not only means a lower risk of margin calls, but also provides opportunities to increase returns as the market recovers. It also needs to be noted that gearing can magnify losses in the same way.
  • A conservatively geared margin loan also means you have more cash free to invest in other asset classes and improve portfolio diversification. Better diversification can reduce concentration risk without reducing overall returns

Conservative gearing can be a simple, powerful strategy for investors to understand that they do not need to borrow huge amounts or take big risks in order to boost their investment returns.

Of course investors should always remember that while margin loans can magnify gains they can also magnify losses.

Margin loans carry the risk of a ‘margin call’ – a requirement from the lender to the borrower to restore the loan to an agreed level if the value of a portfolio falls.

In any investment strategy, it is important to manage the risks

Margin calls can force the borrower to sell shares in a falling market, effectively locking in their losses, shutting them out from longer-term sharemarket growth, and eroding their equity. This can wipe out the benefits of the gearing strategy, and damage their wealth.

However, using a conservative gearing strategy can mean that an investor can enjoy the benefits of gearing and long-term growth in the sharemarket, while reducing the risk of a margin call.

In the following example we show how, by conservatively gearing their portfolio to just 30% and investing in an appropriately diversified portfolio of ASX shares, the investor would have avoided any margin calls over the last 10 years, even through the Global Financial Crisis (GFC).

It is important with any investment strategy to obtain the appropriate level of advice.

Example

In this example we show how an investor who chose a conservative 30% gearing strategy into a diversified portfolio (ASX 200 Index) has had better returns over a ten-year period, but more importantly are better positioned to increase returns as the global economy slowly recovers.

The following analysis by BT illustrates how an investor using a 30% geared margin loan into an appropriately diversified portfolio earned slightly better net average returns over the past 10 years than if they had invested directly. In a challenging sharemarket, every extra percentage point gain can make a noticeable difference to your wealth.

Note that there are some important qualifications to this example being:

  • Investment returns represent the returns received on the ASX 200 Index, and any portfolios that do not mirror this index will return different results.
  • Dividends are based upon the annual yield of the index. They are calculated on an annual basis, as at the end of the period and treated as being reinvested at that time. Assumed full entitlement to franking credit which is subject to the 45-day rule.
  • Tax deductions assume the client is in the highest marginal tax bracket.
  • Interest cost of 8.88%, being the average of the historical BT margin loan rates over the period (Jan 2006 – Dec 2015).
  • Interest is non-capitalised.
  • Brokerage and other fees and charges have been excluded.
  • Franking percentage is based upon the SPDR S&P/ASX 200 Fund.
  • Capital gains tax consequences are not considered in this example. It is recommended you should seek independent professional tax advice of CGT consequences and its impact.

As the global economy tries to recover, the investor is also better placed to achieve greater returns on the back of a period of sharemarket consolidation and the potential for a period of growth by having greater exposure to the market ($173,918 ungeared assets vs $248,454 geared assets). Of course if markets suffer sustained losses, the investor has greater funds at risk.

Just as importantly, the following analysis of the above portfolio over the past 10 years, shows that even during the GFC, the portfolio would not have received a margin call.

Past performance is not necessarily an indication of future performance, and this could change in the future. Source of market Data IRESS Market Technology.

Other important assumptions

Assumptions

  • The maximum LVR and buffer is 80%.
  • The actual risk of margin call for a particular portfolio may also differ from that of the ASX200 Index. The maximum permitted LVR, the buffer, and the trigger point for margin calls on any portfolio will depend on the portfolio composition and the margin lender, and may vary from time to time.
  • The actual benefits and risks of leverage will depend on the portfolio’s construction including any adjustments to the portfolio, whether discretionary or due to corporate actions; the maximum permitted LVR and the buffer allowed for a particular portfolio, and the amount of leverage used; the investment date and the holding period.
  • No representations are made as to future lending policies or interest rates, nor to future returns available from any investment.
  • Gearing of any sort has the potential to magnify both gains and losses, and you may receive back less than your initial investment.
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