CPD: Margin lending – the basics
Margin lending is a form of gearing whereby investors borrow money to invest in shares, exchange traded products (ETPs) and managed funds. There are good reasons to use margin loans, but it is not without its risks. In this article, OpenMarkets examines the basics of margin lending – what it is, how it works, the benefits and the pitfalls.
Australians are used to borrowing money to invest in property, whether it be the family home or an investment property. According to the Reserve Bank Australia (RBA), at the end of 2016 Australian lenders had property loans worth $20.1 billion (owner-occupiers) and $13.8 billion (investors) on their books. Do investors as readily borrow to invest in shares?
The same RBA statistics showed $10.7 billion in margin loans at 31 December 2016 – this however, is significantly less than the peak in December 2007, when lenders had written $41.6 billion in margin loans. This was soon followed by the Global Financial Crisis (GFC) – and margin calls peaked a year later in December 2008, with 8.6 margin calls per day, per 1,000 clients. By that point, the value of margin loans had nearly halved to $23 billion, and the decline has since continued. In fact, the value of margin loans at the end of 2016 was the lowest it’s been since March 2002.
How do margin loans work?
A margin loan is a form of gearing – and gearing means an investor borrows money to invest – in approved shares, ETPs or managed funds, using that investor’s cash or investments as security.
Each different lender will have a list of approved securities, which generally include a broad range of stocks, ETPs and managed funds, and will specify the percentage of the value of each investment that can be used as security. The investor must provide cash or other securities to bridge the difference between this lending value and the total loan.
The amount an investor can borrow is generally determined by three factors:
- the securities held by the investor
- the LVR of those securities
- the investor’s credit limit, based on an assessment of their financial position.
The best way to illustrate how margin loans work is via a case study. Table one illustrates two hypothetical portfolios, showing the total amount available for a geared and ungeared investment of $20,000. By adding a margin loan, the investor has a larger total investment pool.
As illustrated, if the securities held in the portfolio increase in value, the investor can enjoy magnified gains…however, if the securities fall in value, losses are also magnified and investors may be subject to margin calls.
What are the benefits of margin lending?
Investors wouldn’t have circa $10 billion in margin loans if there were not clear benefits for doing so. These reasons include:
Diversification – extra investment capital means a larger portfolio, which in turn allows for diversification across a broader range of assets. A key benefit of diversification is risk reduction; for a geared portfolio, it can reduce the risk that poor returns from one investment will reduce the value of the total portfolio.
Unlocking equity – borrowing against an existing portfolio means that investors can expand that portfolio without having to sell assets to reinvest, which can potentially create a capital gains tax liability.
Potentially increase the quantum of investment returns – as illustrated in the case study, an increase in the value of investments in a geared portfolio can magnify gains.
Tax benefits – dependent on each investor’s individual situation, a margin loan may help maximise after-tax returns:
- investors may be able to claim a tax deduction for interest payments on the margin loan
- investment in shares with fully franked dividends may reduce an investor’s overall tax liability
- many investors use negative gearing to purchase investment properties; the same benefits can be attained from borrowing to invest in securities if the expenses associated with the margin loan are greater than the income received.
Reach financial goals faster – assuming financial markets and the securities within the portfolio increase in value, investors may achieve their financial objectives more quickly than if they did not borrow.
Income benefits – depending on the securities purchased, investors may have access to a greater number of dividends or distributions and, where allocated, franking credits.
What are the downsides of margin lending?
As with any investment, there are several risks associated with margin lending. Because of the amplification effect of gearing, losses (and some other risk factors) will be magnified. The key risks include:
Market risk – a drop in the market generally results in losses; these will be magnified where gearing is employed. Losses can result in margin calls.
Increase in interest rates – increased borrowing costs are generally passed on by margin lenders, increasing the cost of the overall portfolio.
Changes to an LVR – a change to the LVR of a security can lead to a margin call, depending on the size of that investment.
What is a margin call?
As experienced by investors during the GFC, share prices can move down quickly; in such a scenario, the investment portfolio could become worth less than the loan. Through the LVR, margin lenders limit the amount that can be borrowed for each security to protect themselves against such a shortfall – however in the case of a significant fall, a margin call might result.
A margin call is a demand from the margin lending provider to add money or securities to the account. This generally arises when the value of the securities in the portfolio fall below an agreed percentage of the loan. In such a scenario, investors must:
- add funds to the account, or
- add securities to their portfolio to raise its overall value, or
- sell securities to cover the shortfall.
When borrowing to invest in shares, ETPs or managed funds, the margin lender takes security over the investments bought with that loan. These investments can be sold by the lender to repay the loan if the investor is unable to add cash or other securities to the portfolio.
The number of margin calls tends to increase when the market falls; the rate of margin calls for the quarter ended 31 December 2016 was among the lowest since 2000.
The key to successful investment is managing risk. ASIC’s MoneySmart website has a margin lending calculator to help investors determine:
- how the amount borrowed could affect potential gains and losses
- the likelihood of a margin call
- the amount of money required to meet a margin call if markets fall.
Having a sound understanding of the risks involved in margin lending – and a plan to manage them – is essential.
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