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Margin Loans Gearing to buy shares - the real story!?

Discussion in 'Finance & Banking' started by Simon Hampel, 7th Nov, 2006.

  1. Simon Hampel

    Simon Hampel Co-founder Staff Member

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    Given the Australian average for margin loans is around 40% LVR (according to what I've read in the media), we are generally quite conservatively geared when it comes to shares and managed funds.

    Why ? Because they are more volatile investments than property ?

    Or are they ?

    It may well be that shares and funds only SEEM like they are more volatile because they are readily traded, and there is daily information (instant for shares) available on the current market value. This wealth of information can cause emotional reactions, which can lead to irrational decisions about the best course of action.

    Selling your shares or funds because they are going down is not necessarily the best step, even taking into account stop losses and a minimal-loss strategy. It all depends on your goals, and if you are a conservative long term investor, then it could be argued that selling your shares just because they are having a bad month - may well be the worst decision you could make.

    What about property ? We get regular updates in the media that "property has dropped/rised by X% this month/quarter/year" ... but that doesn't tell us what OUR property is worth today, this very instant.

    The real, tangible value of an asset is determined by what the market is prepared to pay right now for it. If I can't sell my shares for $5.20 because nobody is willing to pay that price - then they are not worth $5.20 !!!

    It's no different with real estate. If nobody is willing to buy my property for $295,000 - it's not worth that !!!

    So why don't we get all worried about our real estate portfolio if you can't find someone to buy your property right now for the price you want ? Because we generally don't care about the price right now - we are holding long term, and we'll be happy to wait a month or two to sell the house to get the price we want.

    So why don't we take the same approach with shares ? Why are we not allowed to wait a month or two to get the price we want ?

    Is real estate really more secure ? How come I can get a 95% loan on a house when we don't really know what it's worth because there is no instant market update ? How come I can't borrow as much on a share portfolio which we DO know the exact value of day-to-day ?

    My suggestion is that it's all just a matter of perception.

    Why are people happy to borrow 80%+ on real estate, but will only borrow 50% or less on shares and funds ?

    It's because of fear.

    It's not because they fear the value of the portfolio will go down though - otherwise they wouldn't borrow so much against their property either. It's because someone may well "call them out" on their perceived value of their shares and funds and change the situation. The lender may get nervous and insist that they sell down part of their portfolio (or provide more equity) to limit their exposure to a bad debt.

    It is margin calls that scare people. This mysterious tragedy which the majority of leveraged share investors spend their lifetime fearing, but never actually experiencing.

    But do the sums.

    Following on from Nigel's examples in this thread... what are the returns on your share/fund portfolio geared to 50% ? What would the returns on that same portfolio by over the long term if you had geared to 60% ? 70% ? 80% ? The answer is a LOT more.

    But what is the risk of a margin call ? And what is the true cost of a margin call ? If you can walk the fine line between maximising your LVR whlie never actually receiving a margin call - then you have truely maximised your returns, and will be so much better off than if you were more conservatively geared.

    But how do we know how much is enough ?

    If you have a goal to be worth $X within 20 years, then choosing an overly conservative investment portfolio, with an overly conservative gearing level, may well be a high risk strategy because there a very good chance you won't ever reach your goal.

    Once again, it all comes down to risk.

    Would you choose a lower return that is much more certain to eventuate, over a higher return that has a larger element of risk attached ?

    Most people are fundamentally risk averse - especially when it comes to leverage, and a margin call is seen as a very risky situation - so most people strive to avoid it at all costs. This leads to a tendency to prefer quite low LVRs for shares and funds, despite the fact that a margin lender will offer a much higher ratio.

    Margin lenders don't just offer an LVR based on the direction of the wind. They do their own analysis and determine how much risk they are prepared to take on based on the nature of the assets the fund holds and how well it manages them (or the strength of the company and the returns it offers).

    Interestingly, I can get at least 75% LVR for most of the funds in my portfolio, without any cost to me. What's more they offer up to 10% buffer before initiating a margin call. That's an effective LVR of up to 85% without any cost to me !!!

    However, I can generally only get 80% LVR on my real estate portfolio without cost to me ... any higher and I need to take out insurance for the lender to cover their risks. This is an up-front cost to me that eats into my returns from day 1.

    At face value, this indicates that I may well be better off gearing with shares/funds than with real estate ? Of course it's never quite that simple :rolleyes:

    So is there really that much difference between lending for real estate and shares ? If we could somehow get some form of insurance for our margin loans to protect the lenders from a devalued portfolio - would we leverage higher ?

    Now THERE is an idea for a finance product that could have a big impact on the way average people invest !

    Could we synthesize our own insurance mechanism to minise the potential downside from margin calls ? Has anyone actually done any research into margin call management ? Would holding a cash buffer aside for a margin call situation allow us to leverage to a much higher level without fear ? Would we be better off simply depositing that cash into our margin loan and working from a lower LVR ? I haven't done the sums - but it would be an interesting exercise.

    Ultimately then, the answer to the title of this post is that the REAL story of gearing to invest in shares and managed funds is a story of risk management, and if we have a good enough risk management strategy in place, then perhaps we can indeed start to approach the gearing levels of real estate, and hence find better returns for our portfolio.

    Discuss :D
     
  2. Nigel Ward

    Nigel Ward Team InvestEd

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    The wonderful people at Mac Bank are of course onto this already. They've brought out a margin loan product without a margin call. Instead you have to reduce the LVR by principal repayments of 1% each month.

    Gearing without the crunch: a safer way to build wealth - Business - Business

    Investment Multiplier - Macquarie Bank Limited

    I think it's only offered over managed funds at this stage.
     
  3. Simon Hampel

    Simon Hampel Co-founder Staff Member

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    The Macq product is a good approach - however it still has the same basic problem that self-managing higher LVRs has ... you need cash available in the case of a market fall to be able to fund the Principal repayments that kick in.

    From a cashflow point of view, it's not that different to a margin call. The main benefit from an investment point of view is that Macq don't force you to sell your portfolio - but you still need to find the cash from somewhere.

    They'll also take all your distributions as required to fund those principal repayments - so look out if you were relying on that cashflow for other purposes.

    You also don't get to capitalise interest.

    Macq also limit you to no more than 30% of your portfolio in international or smaller company funds.
     
  4. gad

    gad Well-Known Member

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    A lot of food for thought there Sim.
    Thank you, very interesting.

    Is running the forum(s), thinking about what to post, posting threads, replying to posts & looking after you investments all you do all day?

    I can't imagine you'd have time for anything else. You amaze me.
     
  5. Simon Hampel

    Simon Hampel Co-founder Staff Member

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    Not quite yet. Give me a year or two and hopefully my portfolio will let me do exactly that :D

    In the meantime, I tend to use the forum as a break from my day job. Some people take a smoko, some people take a coffee break, I do stuff with the forum :D
     
  6. perky

    perky Well-Known Member

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    Probably why I am so into CFD's at the moment.
    The worst lend I have is on CBH, at 70% (so I put in 30%)...But its gone up some 40% in the last few weeks, so I am not unhappy about that.
    Most CFD's are 3,5 or 10% , ZFX, PDN are both 5% - which suits me.
    We have also set up some GSLO's (Guaranteed Stop Loss Orders), so most of the profit we will be able to keep if the market corrects. A little costly (CBH GSLO costs 1c per share which equates to above 1%) but its like having insurance.
     
  7. Glebe

    Glebe Well-Known Member

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    Not being able to hit 80% with my managed funds is a real nuisance. I know that if a Sept 11 etc occurs again, the shares will drop 30% but will rebound shortly afterwards. Unfortunately the margin provider won't care and will sell me out at the bottom of the market, so I only leverage to 55%. Otherwise I'd go to the max.
     
  8. Insight

    Insight Brisbane Buyers Agent

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    Bond Corp and Quintex were once Blue Chips

    Sim if you are talking about an index tracking vehicle then fine, if about individual shares then you need to be aware of the attrition rate of all companies and MF's. The assumption that the property titles my RE are place on is a more robust investment in survival terms than many companies in the ASX200 over the course of my lifetime is something I think is true.

    I imagine an index fund is inherently no riskier than generic resi property in terms of risk in a politically stable country like Australia (presently!) if you define risk as your investment going down so far it never recovers or even dissapears.
     
  9. Simon Hampel

    Simon Hampel Co-founder Staff Member

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    Sure, putting all your money into a single asset may have a higher degree of risk if you aren't fully aware of what is happening with that asset (eg internal fraud or mismanagement or other issues which may have a fatal impact on the viability of the company).

    If you are going to gear your investments to a high level, you'd want to make sure you have a degree of diversity built in that will allow for the occasional "dud" investment. Investing in a fund which chooses from 10+ blue chip shares is unlikely to have a serious long term impact if one of those shares were to go bust.

    I don't think it's necessary to invest in an index to get the diversification you need - an index will simply average your returns across a much larger selection.
     
  10. Simon Hampel

    Simon Hampel Co-founder Staff Member

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    Interestingly, I wrote a computer program last night to find out what the largest percentage drop the combined funds in my portfolio has ever had was.

    There's quite a few assumptions - based on buying into the fund at inception (the same amount in all funds), and reinvesting all distributions. I added up the daily value of each of the funds and then found the largest drop from peak to trough (which assumes you timed it to buy exactly at the peak).

    It seems that 2002 was a very bad year for funds!

    My portfolio would have been down 19.5% from peak to trough. This is a lot higher than I expected. I thought my portfolio (quite geographically diversified) might have coped better than this.

    It would be interesting to see how the NavraInvest funds would have performed had they been in operation during 2002 ... it may well have helped keep the portfolio a bit more bouyant.

    This means that I need to ensure a maximum LVR of around 60% to cater for a similar downturn without facing a margin call. Which, ironically, is what I was doing anyway. Of course, this does not deal with a crash - I don't enough data from the funds I'm investing in now to see how they coped in the past.

    In reality, this peak-to-trough situation is unlikely - unless very unlucky with your timing, you won't get quite as large an impact on your portfolio since your average buy price won't be quite as high. But it does show the need to be careful.

    What I need to do is work out a range of scenarios that consider whether it would be better to:

    - run at a lower LVR (ie deposit cash into your margin loan)
    - keep a cash buffer (ie hold the cash aside to fund a margin call if required)
    - just invest it all and deal with a margin call when IF it happens

    There's a lot of assumptions in any scenario - but it would be an interest exercise.
     
  11. Tropo

    Tropo Well-Known Member

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    "What I need to do is work out a range of scenarios that consider whether it would be better to:

    - run at a lower LVR (ie deposit cash into your margin loan)
    - keep a cash buffer (ie hold the cash aside to fund a margin call if required)
    - just invest it all and deal with a margin call when IF it happens"


    Have you considered one more option such as selling part of your portfolio instead of paying cash to margin lender IF you get a margin call. :eek:

    "My portfolio would have been down 19.5% from peak to trough. This is a lot higher than I expected. I thought my portfolio (quite geographically diversified) might have coped better than this."


    Hmmmm 19.5% it’s a lot…Market's bull run from 2003 recouped your losses me think…
    How low you can go the next time if there is a bear market?
     
  12. Simon Hampel

    Simon Hampel Co-founder Staff Member

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    Yes, I guess that is another option - and that is exactly what the margin lender would do if I wasn't able to come up with the cash. Better to control the situation and tell them which investments to sell than to have them arbitrarily choose I guess.

    mmm ... I just looked a bit more carefully at the data I was dealing with and re-did the calculations to make them a bit more accurate.

    My simulated portfolio was made up of CFS WS Property Securities, CFS WS Global Resources, Platinum European, Platinum International and Platinum Japan ... so it's very overweight in international shares, but that's all I have data for readily available right now.

    Anyway, it's still an interesting exercise.

    If I get some more data from other funds into my database I might run the scenario with some Australian funds to see how they fared over the same period.

    The portfolio (remember, $10K invested in each fund at inception with distributions reinvested) would have reached a high point in May 2002 of $132K, followed by a low point in March 2003 of $107K (down 19.1%).

    But by August 2003, the portfolio was back to new highs and reached an all-time high of $238K in May 2006.

    With the downturn in June, the portfolio reached a short term low of $214K (down 10.1%), and by today was back up to $235K - not far off its record highs.

    Remember the portfolio only cost $50K ... and would be worth $235K today!!

    The Platinum Japan and Platinum International holdings would be the main drags down at the moment - neither has performed that well since May - especially the Japan fund.

    Looking at my current portfolio and current LVR, I could handle about 17% drop in market from today before I'd face a margin call, and even at 20% drop, the margin call isn't too large for me to cover from cash holdings.

    I am running a bit higher than I normally would at the moment though ... I'm waiting on some cash from another IP refinance to bring the LVR back into line.
     
  13. Tropo

    Tropo Well-Known Member

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    "Remember the portfolio only cost $50K ... and would be worth $235K today!!."

    I can not argue with that, as long as you can maintain your current gain (more or less) ;)

    "I'm waiting on some cash from another IP refinance to bring the LVR back into line"

    I would do the same.
    You invested in quite few Funds, so watch relevant markets. It can not go up forever...
    Only diamonds are forever.... :D
    :cool:
     
  14. Insight

    Insight Brisbane Buyers Agent

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    backtesting

    Was the criteria for the selection of the tested funds performance?

    I imagine it was solid performance over a 3 or 5 year period if I'm correct in that guess. Which means back tested results will naturally be respectable and of dubious value going forwards.
     
  15. Simon Hampel

    Simon Hampel Co-founder Staff Member

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    The point of this exercise was not to validate fund choices - it was to see just how far they might have dropped from peak to trough in a worst case scenario in which you managed to time the peak perfectly to buy.

    This just gives a bit of an indication as to what kind of buffer you might expect to need to minimise the risk of a margin call.

    Naturally the data I had on hand didn't cover a large enough period to see what might have happened during a major crash - nor did it cover a reasonable range of funds ... there was just the data I happened to have in my database at the time I got the idea to work it out.
     
  16. Insight

    Insight Brisbane Buyers Agent

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    All I was saying was that any indication of peak to trough DD's would be a very poor indicator going forwards due to selection bias (possibly). It's an issue I have faced with my testing results.

    ** edit.. Though if you can get sufficient data and see how your portfolio perfoms over different markets and how they correlate with each other then that seems like a worthwile investment of time to me.

    for selection bias it's worthwile reading a bit about survivorship issues and MF's.
     
  17. Simon Hampel

    Simon Hampel Co-founder Staff Member

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    One of the most dangerous thing for people choosing managed funds right now is the 3 year performance figures published by the fund managers and media.

    We've been through an astounding period of sustained growth - particularly in the Australian markets over the last 3 years, so anyone choosing funds based on their 3 year performance is not getting the full picture of the historical performance, I feel.

    It's worse for funds that have been around for less than 3 years - you don't even get to go back to "interesting" periods like 2002 - 2003 to see how well they coped with those markets.
     
  18. Nigel Ward

    Nigel Ward Team InvestEd

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    Absolutely correct! I'm choosing some funds atm and I'm looking at (amongst other things) the 10 year performance (where available) then 7 year then 5 year...

    As they say, a rising tide raises all boats...but it's only when the tide goes out that you see who's not wearing any shorts. :eek:
     
  19. Simon Hampel

    Simon Hampel Co-founder Staff Member

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    Just be careful to consider what those performance figures really mean.

    If you've just had an amazing year, then it will make your 3, 5 and 7 year returns look a lot better too - even if they were relatively bad.

    I'm thinking of building a performance comparison system which reports on what actual returns a fund got each quarter/year so that you can look at it and say ... mmm if I had bought into the fund in July 2002, I would have actually lost x% ... instead of having that data conveniently hidden through the 3/5/7 year reporting that funds do (which I feel is deliberately misleading).
     
  20. Tropo

    Tropo Well-Known Member

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    I would check funds' performance during bear market mainly during 1987 & 1997 and how long it took them to recover from losses.
    During bull market most of the players are making money. During the bear market most of them are losing money.
    Last 3 years comparison is not long enough and is very misleading.
    :cool:
     
    Last edited by a moderator: 9th Nov, 2006