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Gearing To Enhance Your Investment Returns
By Laurence Kirk*, Hartley Poynton
Having
described last month how portfolio share investment can be used to produce
reasonable returns at relatively low risk, we now look at gearing as a
means of increasing those returns whilst retaining the risk benefits of
diversification, quality and time.
What
is Gearing?
Gearing is the borrowing of funds to invest, to increase the overall return
on the underlying capital. By borrowing additional funds, investors can
increase the size of their investment portfolio. They will increase their
risk, by leveraging their exposure to rising and falling asset values
and to interest rates, but can also reduce their risk through greater
diversification, and can include risk protection strategies. Gearing can
be positive, where returns exceed gross borrowing costs, neutral, where
returns equal borrowing costs, or negative, where returns are less than
gross borrowing costs but greater than borrowing costs net of tax benefits.
A loan will have interest costs, it will require security and will have
a maximum ratio between the security provided and the funds that may be
borrowed. Conditions, such as loan term and insurance may apply.
Property
Loans versus Margin Lending
The most common forms of security for loans are property and shares. These
will comprise the initial capital. With property, a negatively geared
investment loan can be taken out against an investment property, or a
tax deductible 'line of credit' can be drawn for investment against equity
in one's own home. This is probably the most familiar type of investment
loan here in Australia. A loan against shares is called a margin loan,
as it has a 'margin call' structure, designed to accommodate the more
volatile risk-return characteristics of the loan security. Most people's
major investment is in property, and this may then be used as security
for share investment loans. Property is stable, secure and easily understood.
However, investment property can be costly to buy, sell and maintain,
the loan may be expensive to arrange, and the returns are generally fairly
low. Share investments have higher risks, but also have higher returns,
are more liquid, and provide greater diversification. Loans against shares
are more flexible, more liquid, more accessible and can be arranged without
fees or legal costs. The type of loan security used is a matter of circumstances
and choice.
How
Margin Lending Works
The security for a margin loan is generally a portfolio of shares, but
cash and managed funds can also be used. It can be supplied directly by
the borrower, or indirectly by a guarantor. Lenders will have a list of
approved high quality, lower risk securities and managed funds, eg. the
top 300 listed companies on the ASX and the top 200 managed funds, against
which money can be borrowed to buy further shares and managed funds. The
gearing level of different shares that can be used as security will be
rated according to their risk, eg. BHP may be rated at 70%, Goldfields
at 50%, etc. What this means is that in a portfolio containing $100,000
worth of BHP shares, only $30,000 worth of BHP need be supplied as security,
the other $70,000 worth of BHP may be bought with borrowed funds. Thus
a small portfolio can be geared up to a large portfolio and capital gains
and dividend yields multiplied. A 10% gross return on $30,000 could thus
be geared up to a 33.3% gross return. There will be interest costs on
the loan, which should be tax deductible and may be negatively gearable
against other income. Interest rates may be floating, fixed, pre-paid,
paid from external funds, paid from dividends, or capitalised. There will
be a margin buffer of around 5% on the value of the shares that are used
as security, but if their value falls so much that the gearing level is
exceeded, the loan may have to be reduced or further security supplied.
This is known as a margin call.
Risk
Protection
Margin calls may be triggered by adverse market conditions if loans are
highly geared. These should be avoided by keeping the level of gearing
well below that allowed for the shares that are used as security, eg.
blue chip shares with a gearing level of 70% should be geared to a conservative
50-55%. To maintain this gearing level, interest should be paid from external
funds, rather than capitalised into the loan or paid out of dividends.
Further risk protection can be obtained at relatively low cost with a
loan protection facility which insures the value of the shares that are
used as security at a particular price. As with all investments, the individual's
circumstances, goals, risk profile and timeframe must be borne in mind.
The market and portfolio must be monitored and the investments managed.
Market factors affecting interest rates and the value of the loan security
are particularly important.
Gearing
and the Resources Industry Professional
Gearing is particularly useful for investors with significant capital,
high disposable income to service loan costs, and a long timeframe. For
the young, high earning resources industry professional, building up assets
whilst working away in the bush or overseas, it can be used to increase
the rate of wealth accumulation and shorten the time taken to reach their
financial and personal objectives. Gearing cannot be used in superannuation
funds, as they are prohibited from borrowing, but more of that in next
month's article.
*
Laurence Kirk is a senior investment adviser with Hartley Poynton who
has spent 17 years in the mining and oil industries. He specialises in
portfolio investments, superannuation and financial planning for resources
industry professionals.
Tel: (08) 9268 3614
Email: laurence_kirk@poyntons.com.au
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