Make Your Cash Perform

Sydney Morning Herald

Tuesday August 5, 1997

PHILIPPA TYNDALE

Leverage is the buzz word on the sharemarket these days with investors using borrowed money to turn themselves tidy profits.

WITH the share-market riding high and few other ave-nues for keeping the tax bill to a minimum, borrowing to buy shares was the hottest game in town at the end of the 1996-97 financial year.

And it seems investors needed very little encouragement to take the plunge. In the wake of the superannuation surcharge, many investors had already taken the view that leveraging into shares using after-tax dollars was preferable to wearing the additional cost of super.

Leveraged share packages with interest pre-paid before June 30 did a roaring trade. A sustained bull market, investment opportunities from a number of privatisations, new listings and takeovers, combined with the encouragement of advisers, has brought gearing back into fashion after falling out of favour post-1987.

Gearing is now seen as a legitimate strategy for wealth creation, a means of enhancing your share investment by gaining greater exposure to sharemarket gains.

In the same way that a mortgage allows to you to build equity in a property beyond the limitations of your own savings, leveraging into other assets, such as shares, offers the chance to buy into an asset that normally may have been out of reach and to build a bigger stake in that asset. Handled properly, that leverage is the key to turning small amounts of money into large amounts.

Gearing, or leveraging, simply means that you are borrowing to buy an asset. It becomes negative gearing when the interest and other costs associated with the loan exceed the income you receive from the asset and the difference becomes tax-deductible. It is a strategy that relies on the underlying asset increasing in value.

"People should only be negatively gearing where they will get capital growth," says Assyat David, portfolio manager at RetireInvest.

Negative gearing into shares works best for someone in the highest marginal tax bracket, with a good understanding of the volatility of the asset and the cashflow to meet unexpected increases in costs, he says.

Although negative gearing has long been associated in the Australian psyche with residential property, many believe that gearing into shares is a more attractive investment. "Shares may be better for gearing because you have higher rates of return, the benefits of tax franking credits, liquidity and better potential for capital gain," says Scot Menzies, manager of chartered accounting firm McDonald Ross and Company.

But as more people enjoy the enhanced ride up the All Ordinaries Index, there is a danger they will ignore the health warnings on the way. "We shouldn't ruin something good with rampant speculation," says Roger Bacon, executive director of Challenger Asset Management.

There are some prerequisites to successful gearing, starting with choosing good solid assets and having an assured income so that you do not become a forced seller when the sharemarket or interest rates move.

With interest rates at a low point and the sharemarket surging, there is the potential for both a hike in interest rates and a sharemarket correction. If you have entered into a borrowing arrangement where you bear all the risk, you may be looking at both a margin call, where you have to top up your investment, and increased interest costs.

Investors would also do well to be mindful of the reasons why gearing fell out of favour after the 1987 sharemarket crash. Leveraging can be a double-edged sword: while it magnifies the returns on the upside, it does the same on the downside. You can dig yourself into a financial hole if you are not careful in your approach.

Taking on leverage as a way to easy riches without fully understanding the inherent dangers of such a strategy can land you in hot water. For some people, a strong market and ready credit spell trouble. Gearing for speculation is a game only for the brave and foolhardy.

There are also risks associated with the type of borrowing you are undertaking. David Williams, general manager of marketing at RetireInvest, says the quality of the borrowing is almost as important as the quality of the asset into which you are buying.

Lending for share purchases is an area of financing where permutations are emerging at lightning speed. The spectrum runs from margin lending to fully protected products, instal-ment plans, home equity loans and endowment warrants. The market for one share purchase financing tool, margin lending, is now estimated at $3 billion.

There is nothing to say that you have to go out on a limb in leveraging into an investment. Some people will only be com-fortable where there is a soft cushion to fall on and will pay the interest rate penalty to buy a protected product that shields investors from potential losses through hedging techniques.

For small investors, the safest way to borrow for shares is to start modestly and gradually build equity in the leveraging arrangement, says Peter Thorn-hill, general manager at MLC Investments. "As the asset base grows, your comfort level grows as well," he says.

Thornhill likens gearing for investment, as opposed to spec-ulation, to a company borrow-ing. "Most sensible companies will use a modest amount of debt to enhance the returns from their endeavours.

"Debt can be used sensibly to acquire long-term assets for most businesses. From my point of view, I find leveraging or gearing to be a very sensible and prudent strategy for the long-term because I am pre-purchas-ing retirement assets," he says.

"If you can buy equities for five to 10 years before retire-ment, preferably 10 to 15 years, you've learnt to live with the short-term fluctuations, the asset base has had time to establish itself and grow and the dividend streams that asset base is now creating for you are meaning-ful," he says.

Margin lending is generally considered to be at the riskier end of the leveraged shares market because the investor bears the risk for sharemarket fluctuations.

Banks traditionally prefer bricks and mortar as security but most of the major margin lenders, which include BT, Leveraged Equities, Deutsche Morgan Grenfell, Citibank and ANZ, will use the value of a share portfolio as collateral to borrow for shares, usually with a maximum level of borrowing of 70 per cent of the value of the shares. The minimum loan amount can range from $20,000 to $100,000.

Margin lending is a form of financing that best suits an experienced investor with an active interest in their portfolio and one with the cash flow to face up to a margin call. A margin call occurs when a fall in the value of your shares brings your gearing level or loan-to-value ratio above the maximum. It usually means you have 24 hours to put in more cash or investments to bring your gear-ing back into line.

You can regulate the level of risk you adopt by lowering the level of gearing; the lower the borrowings, the lower the risk.

Advance Funds Manage-ment's Carl Scarcella says many investors are well aware of the margin call risk and are not borrowing up to the full amount. This sentiment is echoed by Leveraged Equities' marketing manager, Hugh Latimer, who says the average level of borrow-ing is 54 per cent of the value of the asset.

With further large privatis-ations and new listings on the horizon - Telstra and AMP are the two most notable - margin lending will become a much bigger business, says Latimer.

While interest rates on this type of lending are about 8 per cent, interest rates on protected products can be between 13 per cent and 20 per cent. Although this has been the major factor inhibiting the success of pro-tected margin lending, there will always be investors who will pay the added cost to sleep at night.

Macquarie Bank pioneered the protected lending market through its Geared Equities Investment. Macquarie will pro-vide a minimum loan of $100,000 for one to five years and investors can borrow up to 100 per cent of the cost of the share portfolio. For an addi-tional amount you can lock in your profits on pre-determined date so, if the share price falls after that date, your gains are preserved.

Scott Young, a divisional director of Macquarie Equities Lending, says the market for the Macquarie product is quite different from that of margin lending. "It attracts people who are risk-averse, long-term inves-tors."

Several institutions - includ-ing Advance and Colonial - allow you to gear into managed funds through instalment plans. Advance Funds Management has recently introduced a "no-margin call" option on both its gearing and instalment gearing into managed funds. It has a slightly different twist in that it comes at only 1 per cent above the usual interest rate, as opposed to most protected products which can charge up to 6 per cent above normal lending rates.

One of the advantages of buying into a managed fund or shares in this regular way is that you can take advantage of dollar-cost averaging. You buy more shares or units when the price is low and fewer when the price is high and it averages out the overall entry price. In the-ory, it irons out the problem of getting your market timing right.

Opportunities for leveraging into shares now include many more home equity loans that allow you to borrow against your home or an investment property at a reasonably low interest rate, with some banks lending up to 90 per cent of the value of the home. Citibank, Westpac and Colonial State are three of the larger players in this market.

Jim Clegg, a principal consul-tant at financial planning firm Godfrey Pembroke, says that borrowing against a home, where you have a line of credit and can buy the shares on your own schedule, is his preferred way of gearing to buy shares. "You retain control and flexibil-ity and are not exposed to margin calls," he says.

Clegg also recommends hav-ing a buffer against share fluctuations and unexpected expenses. So if you want to invest $200,000 in shares, you set up a loan facility for $250,000 and leave $50,000 undrawn. Taking out adequate income protection insurance is also vital, he says.

Earlier this year, Leveraged Equities launched PowerHouse, aimed at high net worth individ-uals, which will lend up to 80 per cent of the value of a property to a maximum of $750,000. It draws the line at using a person's own home as collateral, but will allow residential investment property, shares, managed funds and cash as security.

Endowment warrants are another product that has taken off in the past year, particularly with do-it-yourself superannua-tion funds. These are a long-term leveraging product, with a time-frame of five to 10 years, that still allow you higher exposure to the sharemarket.

With warrants, the investor puts in between 30 and 60 per cent of the cost of buying the underlying shares and the rest is provided by the issuer. The outstanding amount, including interest, principal and costs, is paid off over five or 10 years by the dividends earned on the shares. An investor can acceler-ate ownership by ploughing back rights and Bonus issues.

Unless you buy the protected form of warrant, you are still exposed to the increased volatil-ity of leveraging. However, unlike margin lending, where you can lose not only your capital but the money you borrowed, the downside risk is limited to the original amount paid for the warrant.

Dollar-cost averaging: Investing a set sum at regular intervals

Margin call: Adding cash to bring your gearing

into line after a share-price fall