Investing in the sharemarket with a margin loan is no longer regarded as an easy way to make money quickly. The sharemarket is struggling and tracking sideways and high-profile crashes have called into question the value of the strategy.
Margin calls inflicted big losses on many investors - big and small - who had borrowed too much when the sharemarket crashed in 2008. Since then, regulations have been introduced to curb the aggressive sales culture that took hold in sections of the margin-lending industry as the sharemarket reached dizzying heights.
If approached conservatively, margin loans can benefit high-income earners who have cash buffers. But even then, investors need to do the numbers carefully to see if such a strategy is worthwhile.
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''The strategy was knocked for six by the crash of 2008 but perhaps might be worth looking into for wealthier risk-takers with cast-iron stomachs or money they can afford to lose,'' the chief executive of Challenger Life, Richard Howes, says.
Until the GFC, borrowing to invest in shares had become standard for many financial advisers. High-profile collapses put that strategy under the spotlight. These include the clients of Storm Financial, who were advised to over-gear and who lost savings and homes, as well as the wealthy, who borrowed millions through brokers such as Opes Prime.
Magnified losses
Gearing magnifies the gains on the shares but it also magnifies the losses and therefore investors have to '''have their eyes wide open, be informed and know themselves and their tolerance for risk'', the chief executive officer of the Association of Financial Advisers, Richard Klipin, told Weekend Money.
Borrowing to invest can be a worthwhile strategy if it is approached in the right way but over-gearing can be a recipe for disaster, he says. That's what the clients of Storm Financial found out to their cost after they were advised to gear into shares through managed funds.
The ''cooky cutter'' advice was particularly aggressive. Clients were in fact ''double'' geared into the Australian sharemarket - once by borrowing against their homes and again by borrowing using a margin loan.
Many had to sell their homes to repay their lenders and were left to rely on the age pension.
When the sharemarket collapsed in 2008, many investors with margin loans were hit with margin calls and were forced to sell their shares at big losses in order to restore the loan-to-valuation ratios required by the lenders.
Rapid growth
Reserve Bank data shows that margin lending grew rapidly between late 2000 and 2007, with outstanding debt rising from about $7 billion to a peak of $38 billion and the average loan size increasing from $80,000 to $190,000 over that period.
Following the collapse of the sharemarket in 2008, as at September 2009, the value of outstanding margin debt had roughly halved from its peak to about $18 billion.
Gearing was never meant to be a way of getting rich quickly, financial planner and co-founder of Eureka Financial Group, Greg Cook, says.
He explains the strategy can be suitable for high-income earners who have a tolerance for risk, are in secure employment and who are already maximising their opportunities to make salary-sacrifice contributions to a superannuation plan.
''Gearing is an effective strategy to grow wealth but it brings with it more risk,'' the head of advice development at Ipac Investment Services, John Dani, says. He adds that it is important to first test whether the investor's objectives can be met by some other strategy without taking on the additional risk inherent in gearing.
Low gearing
For higher earners, there are tax advantages when the investment is negatively geared. This is where the costs of investing, such as the interest payments, exceed the income from the investment. The shortfall can be used by the investor to reduce the income tax they pay.
Cook says the minimum investment time-frame for a gearing strategy is seven to 10 years. Margin lenders allow progressive draw-downs, where a dollar can be borrowed for each dollar put up by the investor.
Cook advises those with a gearing strategy to make monthly contributions into the investment rather than a lump sum - a strategy known as dollar cost averaging - to average out share prices.
A financial planner with WLM Financial Services, Laura Menschik, says the maximum gearing ratio should generally be 50 per cent or 60 per cent.
A loan-to-valuation ratio of 50 per cent is where for each dollar of the investor's own money, one dollar is borrowed. A conservative loan-to-valuation ratio minimises the chances of margin calls.
Market outlook
Most planners believe those with a mortgage are better off borrowing the money through a home-equity loan than a margin loan as the interest rate can be substantially less. Reserve Bank data shows that in April, the average interest rate on margin loans was 9.65 per cent, compared with an average interest rate on home-equity loans of 7.9 per cent.
Menschik says it may be wise to tap into home equity to invest. She says that with interest rates expected to rise, investors may be better off fixing the home-equity interest rate.
A financial planner with Paramount Wealth Management, Wayne Leggett, favours borrowing against the house. As well as lower interest rates than a margin loan, investors are ''in control'' without the risk of a margin call. A gearing strategy into shares should only be approached very conservatively so the risk of there ever being a call on the house by the lender becomes extremely remote.
However, as there will be a negative cash flow on the investment, investors are banking on a certain level of appreciation of share prices over the long term (see box). So, a positive view on the performance of shares is needed for anyone that's even considering a gearing strategy.
''There's no evidence we're about to experience sustained market growth,'' Richard Howes says.
Source http://www.smh.com.au/
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