Most of us would have a mix of asset in our investment portfolio - ranging from the low-risk, low-return government guaranteed bank account, through stock and real estate investments, and up, up and away into the stratosphere of geared, high-risk, high-return investments. Rather than invest in just one asset class of investment product that matches my risk-tolerance and desired return I have a mix of different investments, accumulated over time via deliberate diversification strategies and a large dose of "it seemed like a good idea at the time" strategy. In this post I'll look at what is probably my highest-risk investment, track how it's performed so far, and establish a baseline for keeping an eye on it's long-term performance over the coming years.

Investment: Hedge Fund (Macquarie Equinox Select Opportunities Fund), 100% geared using funding from a Macquarie Structured Products Investment Loan and annual interest payments capitalised using a line-of-credit loan against my property portfolio equity.

Principal Loan: $50,000 borrowed for the initial investment @7.75%pa fixed, paid annually in advance each June ($3,875 pa interest)

Interest Capitalisation Loan: The $3,875 pa interest payment on the principal loan amount is borrowed each June using my home equity line of credit, @ current variable home loan interest rate -0.7% "professional package" discount +0.1% "portfolio loan" premium. Currently the interest rate is 7.33% pa. This interest is paid monthly from my credit union savings account. (I could have also capitalised this interest on interest, but I couldn't be bothered as the amount each month is quite small, and I'd be pushing my luck regarding the tax-deductibility of such interest payments).

Investment Performance:
14.46% in the first year

Tax Considerations:
In order to ensure that the interest on any loan used to purchase the investment is tax deductible, the Macquarie Equinox fund is designed to pay a small "dividend" each year - estimated in the PDS to be around 1% pa. The dividend for the year ended 30 June 2007 will be declared by the end of August. For the evaluation of the tax effects of this investment I've assumed a 1% dividend is declared.

Taxable income from investment: 1% x $50,000 = $500

Deduction for interest paid on investment loan:
7.75% x $50,000 = $3,875

Deduction for interest paid on capitalised interest:
7.33% x $3,875 = $284

Net effect on taxable income:
$500 - $3,875 - $284 = $3,659 reduction

Marginal income tax rate = 30%
Reduction in income tax payable for 2006/7 FY: 30% x $3,659 = $1,097.70

Unrealised Capital Gains for 2006/7: 14.46% x $50,000 = $7,230
Capital Gains tax rate = 50% x marginal income tax rate = 15%
Unrealised CGT due when investment is liquidated: 15% x $7,230 = $1,084.50
Net Unrealised Capital Gain: $7,230 - $1,084.50 = $6,145.50

Net after-tax profit calculation:
= Investment Value - Loan balance - interest paid + tax refunds - CG tax due
= $57,230 - $53,875 - $284 + $1,097.70 - $1,084.50
= $3,084.20

It's a bit hard to work out a ROI as I used OPM to fund this investment, but as a ball-park figure I assume that I "used" $3,875 of home equity that could have otherwise been invested elsewhere, plus I paid out $284 in interest on this home equity loan. So, ROI becomes $3,084.20/($3,875+$284) = 74.16%

On the face of it this looks like a great little money-maker, BUT the potential riskis huge. Worst-case the investment could become worthless, leaving me with a $53,875 in debt to repay. So, as nice as a 74.16% pa return is, I'll restrict my total investment in this high-risk asset class to the current $50,000 - which is around 4.3% of my net worth. This limits the potential maximum loss to around $88,750 after ten years, vs. a "likely" net profit of around $90,980 after ten years (assuming interest rates stay the same, tax rates stay the same, and the investment return averages 14.5% pa).

Break even requires an averaged investment return of 5.98% pa (It's less than the cost of borrowing to invest due to the tax effectiveness of the investment).

Best-case scenario would be a net profit of $191,674 if the investment return averaged 20% (a figure quoted in the PDS as a "projection" based on historical returns for the underlying investments used to value to investment). This best-case scenario is highly unlikely, with the "historic" return data for many of the underlying investments being only a couple of years!

Doing a back-of-the-envelop estimate of "probable" outcome, I get the following:
Outcome Probability Scenario
-$88,750 10% Stay invested for 10 years, then investment goes bust
-$ 6,930 20% Stay invested for 10 years, investment return avg 5%
$16,264 25% Stay invested for 10 years, investment return avg 8%
$90,980 25% Stay invested for 10 years, investment return avg 14.5%
$131,567 19% Stay invested for 10 years, investment return avg 17%
$191,674 1% Stay invested for 10 years, investment return avg 20%
The Weighted average outcome is a profit of $43,464. (As a reality check this equates to an average return of 10.77%, which seems realistic)

Overall, I estimate that the likelihood of losing my entire 4.3% of net worth that I've put into this high-risk is only around 10%, and that there's a reasonable chance that this investment could increase my net worth by an extra $100K to $200K in ten years time.

This is a good illustration of how slack my investment due-diligence and risk analysis really is. Checking through the PDS again I found that:
a) The 10-year historic return of the underlying investments is actually around 15%, not 20%
b) This investment is supposedly "capital guaranteed" - so worst-case I *should* get back the initial $50,000 at the maturity date
c) There is a "rising guarantee" that "locks in" a part of the increased fund value each year (if any) - this may mean that by the end of August the rising guarantee has increased to maybe $53,000 - which would then become my "worst-case" scenario
d) The investment matures after 8 years, not 10. But at that time the fund "rolls over" into an investment in the top-10 ASX listed stocks, so it won't trigger a CGT event at that time. I may need to refinance to $50,000 loan at that time though.
e) I really don't understand exactly what mix of underlying investments the fund performance is linked to and I don't know what fees are being siphoned off - probably a lot, as exotic investments tend to have high management fees, and capital protected products tend to be loaded up with hidden costs.

So I've violated the cardinal rule to "only invest in things you understand". Then again, although $50,000 is a sizeable investment in one product, it's only 4.3% of my total net worth, and an even smaller % of my total investment portfolio. And some of the benefits (income tax deductions, investment asset diversification into non-correlated asset classes) are pretty certain.

If I was a more risk-averse investor I'd not invest in this product in the first place - instead I'd make a "risk free" 7.33% after-tax ROI by not drawing down my home equity loan to pay the interest on this investment.

On the other hand, a more risk-seeking investor might add $50K or $100K of such an investment to their portfolio each year, using every bit of available equity to fund the investment borrowings. If things worked out, after ten years you could have made an extra $1m or so and be able to retire, or possibly write a book and teach seminars on how to make a fortune through speculative investing

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Enough Wealth 2007

Probably not, but the financial institutions would. Aside from the amounts I owe on our property mortgages and stock portfolio margin loans, I have the following unused credit limits available:
Credit Cards
#1 $9,250 @ 18.99%
#2 $23,000 @ 17.49%
#3 $8,000 @ 14.74%
#4 $45,000 @ 11.99%
#5 $17,000 @ 13.74%
#6 $27,000 @ 12.99%
#7 $20,000 @ 15.95%

Mortgage redraw available
$50,800 @ 7.37%

Portfolio Loan (like a HELOC)
$138,000 @ 7.47%

Stock Portfolio Margin Loan available cash amounts
#1 $85,985 @ 9.15%
#2 $34,859 @ 8.90%
#3 $60,170 @ 8.85%

Overall approved credit available:
$519,064 @ 9.97% average interest rate

It's interesting to see how much the standard rates on my various credit cards vary. Of course most of these cards aren't in use - they were only used for 0% balance transfer arbitrage and have no outstanding balance. The one CC I use for all day-to-day bill payments and shopping usually has a monthly balance of around $2,000-$3,000 which is paid off in full each month.

The margin loans limits are also just for making a cash withdrawal (ie. 0% margin value), if they were used to purchase stocks the available funds would be 2-3x the listed amounts.

I only use credit to purchase investments, and nothing too speculative, but it's easy to see how someone could get into a LOT of trouble if they were to suddenly make use of the credit that is on offer to make "lifestyle" purchases... Of course the lenders aren't too worried since most of this lending would be secured against real estate or company stock, with the maximum possible LVR getting to around 75%-80% if I maxed out my credit.

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Enough Wealth 2007

Mighty Bargain Hunter recently posted about paying off Mortgage debt sooner rather than later. The point being that a mortgage is like any other debt and in the early days of a loan the interest cost eats up a huge amount of each repayment, so making some extra payments can have a huge impact in getting the loan paid off sooner.

However, while it is true that most people want to pay off their home loan as soon as possible, or at least before they retire (so they don't have to fund loan repayments out of their retirement income), it's not true of all mortgages. In particular many people will borrow to invest in a rental property, and, at least in Australia, most of the long term benefit of this type of investment is expected to come from eventual capital gains, rather than the rental income. For example, rent yield is taxable income, but at around 3%-4% of the value of the property, it will be less than the tax deduction provided by the interest on the property loan (say 8%). This means that you will be losing money on the investment property on a cash flow basis, at around 4% of the property value each year (this is known as "negative gearing"). But this interest is tax deductible, so 30%, 40% or more of this amount is effectively being paid from money you'd otherwise lose to income taxes anyhow. The payoff comes (hopefully) when the property is eventually sold for a capital gain. As the Capital Gains Tax rate for assets held over 12 months is half the normal marginal income tax rate the total return on the investment property (rent plus capital gains) can be slightly less than the interest cost and you will still end up ahead due to the tax savings. Many property investors therefore choose to use "interest only" loans for the purchase of investment properties, and would choose to use any spare cash flow to pay interest on an additional investment property rather than pay off principal on one of their investment properties. Not to say that this is the best option for all investors, or even most real estate investors, but it just goes to show that paying off the morgage as fast as possible doesn't apply in all situations either.

Enough Wealth

As the end Australian financial year draws to a close on 30th June, it's time to make arrangements to pre-pay up to 12 months interest on my margin loans. I owed $116K to Comsec, so I prepaid the next 12 months interest on $100K of the balance. I also took up the option to capitalise the prepaid interest. I had some other funds sitting in online savings accounts, so I used that money to repay the remaining $16K of variable rate margin loan. This will mean that I don't have to make monthly interest repayments on the Comsec account for the next 12 months.

I expect I'll soon receive the paperwork to prepay interest on my other margin loan account with Leveraged Equities. I currently have $150K prepaid with them, which I'll reduce to $140K as I have around $6K sitting within the cash management account in my LE due to recently selling my Qantas shares. I'll put that money towards the interest prepayment, so I'll only have to come up with another $6K for the interest prepayment. This will leave only a few thousand dollars of margin loan debt requiring monthly interest payments.

One benefit of making the interest prepayment is that you get a slightly lower interest rate than the monthly variable rate (but this is offset by the opportunity cost of the prepaid interest amount for an average of 6 months). But the main benefit is that you bring forward the tax deductible interest expense by 12 months, so you gain an extra tax deduction the first year you do this. However, each subsequent year you are simply using the prepayment of the next year's interest to substitute for the current year's interest (that was prepaid the previous tax year). At some time in the future you have to unwind the prepayment arrangements by having a year with no tax-deductible interest payment, or possibly a series of years with slowly decreasing interest deductions. I plan to schedule this to occur when I'm retired and over 60. At that time (under the new Simpler Super rules) I'll be living off tax exempt Superannuation pension income, so the tax I pay on any dividend income from my margin loan portfolio will be very low, so getting the tax deduction for interest payments will no longer matter.

Anyhow, interest prepayment on margin loans is just the "icing on the cake" - the main benefit of using margin loans is to get a bigger stock portfolio, but have tax deductible interest payments slightly larger than the dividend income from the portfolio. This basically means that you have no net taxable income from the stock portfolio, and instead only make capital gains on the portfolio. If the gains are on assets held more than 12 months before sale, the applicable tax rate is half your marginal tax rate.

Enough Wealth

I had planned on selling off my portfolio of Australian stocks during the next financial year to reinvest the proceeds within our SMSF, but I've decided against this course of action as the realized capital gains would minimize the benefits of shifting the investment into the tax-sheltered SMSF. Instead I'll just salary sacrifice a large part of my salary into super each year (up to the A$50K deductible contributions limit). Since I'm not planning on selling off my portfolio in the next year I've decided to prepay 12 months interest on the bulk of my margin loan balances, so that I can take the usual tax deduction this financial year. For my Comsec loan I've sent in the paperwork to prepay $100K out of the $116,612.16 loan balance, at an interest rate of 8.75%. If I have any spare income during the year (eg. from takeovers) I'll pay off the remaining $16K of variable rate loan remaining. I'll also prepay $120K of the $150K loan balance on my Leveraged Equities margin loan before the 30th June.

For the next two years I'll be supplementing my salary income with the $34K I withdrew from my superannuation account. This will allow me to salary sacrifice at a high rate for those two years. After that time I'll look at slowly selling some of my Australian stock portfolio each year to allow me to continue salary sacrifice into our SMSF. If I get enough pay rise in the next couple of years to offset the amount I wish to salary sacrifice, I'll retain the existing stock portfolio holdings until I retire, at which time I'll have a very low assessable income (under the new Simpler Super rules pension income isn't taxed after you turn 60) and I could then sell off a portion of my holding each year without accruing much CGT liability. Until 75 I would still be able to contribute the proceeds into super while drawing a pension. After 75 I wouldn't be able to contribute into my own super, but I could start to contribute any excess funds into the super accounts of DS1 and DS2. Under current rules up to $150K a year of undeducted contributions could go into each of their accounts each year. As they will be in their 30s by that time I don't expect that they would be contributing that much into their super accounts yet.

All this planning assumes that the superannuation tax rules don't change much in the next 30 years - a most unrealistic assumption! This plan will obviously have to be updated as the rules and our financial situation changes over time.

Current holdings:
Leveraged Equities Account (loan balance $150,000.00, value $316,303.73)
stock qty price mkt value margin
AAN 295 $15.22 $4,489.90 70%
AEO 1,405 $2.04 $2,866.20 65%
AGK 510 $15.32 $7,813.20 70%
AMP 735 $10.01 $7,357.35 75%
ANN 480 $12.00 $5,760.00 70%
ANZ 1,107 $28.78 $31,859.46 75%
BHP 748 $31.06 $23,232.88 75%
BSL 781 $11.27 $8,801.87 70%
CDF 6,943 $2.02 $14,024.86 70%
CHB 118 $51.01 $6,019.18 65%
DJS 2,000 $5.13 $10,260.00 65%
FGL 3,751 $6.27 $23,518.77 75%
LLC 481 $19.82 $9,533.42 70%
NAB 316 $42.40 $13,398.40 75%
QAN 2,175 $5.06 $11,005.50 70%
QBE 983 $31.56 $31,023.48 75%
SGM 830 $27.08 $22,476.40 70%
SUN 963 $21.16 $20,377.08 75%
SYB 2,880 $4.37 $12,585.60 70%
TLS 5,000 $4.78 $23,900.00 80%
TLSCA 3,000 $3.31 $9,930.00 80%
VRL 1,500 $3.20 $4,800.00 60%
WDC 783 $20.77 $16,262.91 75%

Comsec Account (loan balance $116,612.16, value $229,848.59)
stock qty price mkt value margin
AGK 240 $15.32 $3,676.80 70%
AAN 139 $15.23 $2,116.97 70%
APA 4,644 $4.22 $19,597.68 70%
ASX 200 $48.39 $9,678.00 70%
CBA 130 $55.03 $7,153.90 75%
CDF 43,997 $2.02 $88,873.94 70%
IPEO 54,000 $0.019 $1,026.00 0%
IPE 8,000 $0.995 $7,960.00 60%
IFL 1,300 $10.25 $13,325.00 60%
LDW 1,350 $7.81 $10,543.50 0%
NCM 300 $21.68 $6,504.00 60%
OST 2,000 $6.52 $13,040.00 70%
QBE 607 $31.60 $19,181.20 75%
RIO 60 $94.55 $5,673.00 75%
THG 4,000 $1.02 $4,080.00 50%
WBC 300 $26.03 $7,809.00 75%
WPL 220 $43.68 $9,609.60 75%


Changes to portfolio since last update:

I sold my Qantas shares on the market for $5.39 on the last day before the takeover offer closed. I guessed correctly that the APA offer would fail to reach the required acceptances to proceed, and over the next few days the QAN share price dropped, as had been expected. However I had expected the price would drop to under $5.00. In fact the stock price has since increased after the Qantas management released an upbeat assessment of their prospects, and is now trading around $5.60. The proceeds of the sale reduced my loan balance below the $150K I had prepaid interest on for this financial year, so Leveraged Equities automatically moved the surplus amount into the linked Cash Management Account so I'm at least getting some interest on this bit of borrowed money.

My AMP holding increased by 15 shares due to a dividend reinvestment. I no longer enrol in DRP for new stocks I buy as there is little if any price discount and the hassles of keeping records for CGT calculation outweighs the benefits. I simply use dividends to help pay the interest on my margin loans.

My QBE holding increased by 17 shares due to a dividend reinvestment.

My SUN holding increased by 113 shares due to a Share Purchase Plan offer I took up.

My SYB holding increased by 32 shares due to a dividend reinvestment. This company is currently subject to a take over offer, which pushed the price up from $3.70 to $4.37. As the offer is a cash plus stock mix I may decide to sell my holding on the market rather than accept the offer.

I happened to come across the website for

Shearwater Capital the other day. Their investment approach seems sensible and their published fees reasonable, but that isn't what caught my eye. I was more interested in their model portfolios and using the data on the 20-year performance to evaluate the effectiveness of gearing as an investment strategy.

Looking at their "Aggressive" portfolio (80% stocks/20% bonds, which is similar to my target asset allocation) you have a Twenty Years Annualized Return of 12.3% with a Thirty Three-Year Model Annualized Standard Deviation 11.8%. The "Very Aggressive" portfolio (100% stocks) has a Twenty Years Annualized Return of 13.7%, but the Thirty Three-Year Model Annualized Standard Deviation shoots up to 14.6%.

This shows that, as can be expected from modeling of the efficient frontier of a portfolio composed mainly of stock and bonds, the optimum return-risk outcome is achieved from a portfolio comprised mostly of stocks, but with some bonds included. The mix within the stock component is usually around 60% domestic:40% foreign, although in various ten-year periods you would have done better with the opposite ratio (so a 50:50 split may be a good bet).

Moving from the "Aggressive" to "Very Aggressive" asset mix boosted returns by 11.38%, but the "risk" (variability of returns, as measured by the Standard Deviation) increased by 23.73%.

For this reason, if you are seeking higher returns over long time periods, it seems a better strategy to use gearing of an "Agressive" portfolio, rather than moving to a "Very Agressive" portfolio.

Taking the Twenty Years Annualized Return of the "Very Conservative" portfolio (100% bonds) as a proxy for the interest rate cost of gearing (via margin loans or a real-estate backed investment loan such as a HELOC), one can make a rough estimate of the Twenty Years Annualized Return and Thirty Three-Year Model Annualized Standard Deviation that would result from a 100% geared (50% LVR) "Aggressive" portfolio:
20-year 33-year
Annualized Annualized
Return Std Devn
Ungeared "Aggressive" 12.3% 11.8%
Estimated Cost of Loan 5.9% 2.4%
Estimated 100% geared 18.7% 23.6%
Estimated 22% geared 13.7% 14.4%
Ungeared "Very Aggres." 13.7% 14.6%

Using gearing could therefore increase your average returns by 52.03% at the cost of increasing standard deviation by 100%. This is somewhat better than shifting your asset allocation from "Agressive" to "Very Aggressive". However, the absolute "risk" has increased 100% compared to 23.73%, so the strategy of making use of 100% gearing ratios should probably be called "Hyper Aggressive". A more modest use of gearing (say, 22%) would produce similar average return as a "Very Aggressive" asset allocation, but with a slightly lower standard deviation.

It was interesting to see that the returns for the 100% geared "Aggressive" portfolio are very similar to the long-term increase in value of my own investment portfolio. When I started out I didn't use gearing and had a more conservative asset allocation, but this was offset by the relatively large impact my savings had at that stage. These days my savings have a more modest impact on my overall increase.

One final note, when using gearing the cost of funds (interest rate and any annual fees) can have a major impact on the long-term performance of this strategy, so it is worth shopping around.

Enough Wealth

I've been building up a portfolio of US stocks (my "Little Book" portfolio) since the middle of last year. One of the problems of trading US stocks from Australia has been the relatively high brokerage costs - using Comsec-Pershing it costs AUD$65.00 per trade. E*Trade Australia charges even more, and I haven't been able to find any Australian brokers that will trade US stocks more cheaply. Some readers have recommended US-based brokers which are cheaper, but before I take that route (with the associated hassles around transferring funds in USD to a US brokerage before making trades) I've decided to experiment with using Contracts for Difference (CFDs). These are quite a popular tool for day traders, as you can gain market exposure with low costs per trade (as little as $1) and trading CFDs has a built-in gearing effect (usually the trades are based on a margin of between 5% and 20% of the stock value being traded). I don't intend to try day trading (I think it's a zero sum game, which generally just transfers wealth from the casual day trader to commercial traders), but it looks like it may offer a cheaper method to implement by US stock portfolio strategy.

I applied online for an account with CMC Markets on Friday, and today their representative phoned to request a fax of some identification (drivers licence and a rates notice) to finalise opening my account. As soon as this is processed I'll be sent a login and can transfer the initial $1000 required to begin trading. Although there is a normally a monthly fee of around $40 to use their trading software with live stock price data from the ASX, as I only intend to trade US stocks this data isn't needed and I won't have to pay any monthly fee.

Trades of US stocks are generally on a margin of 5%, so I should be able to buy a CFD to gain equivalent exposure to a US stock as my Comsec-Pershing $5000 trade for only $250. The minimum fee of $10 is high as a percentage of the trade value (4%), but is very reasonable compared to the underlying stock exposure (0.2% of $5000). I'm not sure that all the US stocks I've picked for my "Little Book" portfolio would be available as CFDs - only 541 "constituents" of the US market are available from CMC markets.

There's also a fundamental difference between buying stocks and trading CFDs - in the case of CFDs you are basically buying a promise from the issuing company, in this case CMC Markets. The CFDs issued by CMC Markets are not tradeable by any other CFD company, and if CMC Markets went out of business my investment in their CFDs would be worthless.

Anyhow, to replicate my actual US stock trades with Comsec-Pershing over the next 12 months (US$60K worth) will only cost me around US$3K to buy the equivalent CFDs, so it's not going to be a hugely expensive experiment whatever happens. If it works out I could save US$600 a year in trading costs, which would add directly to the ROI of my "Little Book" portfolio.

I've finally bitten the bullet (gently) and bought my first real "derivatives" - I placed an order today to BUY 3 contracts for the S&P/ASX-200 index PUT option, 20-Dec-2007 expiry date. Each contract is for 1,000 'shares' (a strange terminology when you're buying index options) and the price range quoted when I placed the order was $1.44-$1.63. I started out telling the broker to set my buy price at $1.50 but he advised that this would take a long time to fill. I asked if the price varied more with time (ie. as we get closer to the expiry date the price should drop) or with the current value of the index (once you are "in the money" the contract is worth $10 per point at the expiration date). He wasn't terribly helpful, so I decided to bid $1.60 - so hopefully this order was filled.

The whole options trading thing is a bit of a pain - rather than just login and place an order with my normal online broking service, they have a special "power trader" application that provides live option pricing, charts etc. I looks really cool, but unfortunately I can't install it at work, and options trading is only available during market hours, so I can't use the software to trade options at home anyhow. So I have to phone the broker during business hours to trade options. Probably a good idea to start with, as I don't really know what I'm doing.

My geared stock portfolio is worth around $525,000 at the moment, with margin loans of $264,000. Hence my equity is around $261,000 at present. Although my portfolio doesn't exactly track the ASX-200 index, it does have a high correlation with the index. A change in the ASX index of 1 point is worth about $90 to my equity. Thus at my current gearing level a 2900 point drop in the index (just under 50%) would wipe out my equity entirely (but I'd be getting margin calls long before that!).

As each 1 pt decline below 5500 is worth $10 at the expiration date of an ASX200 5500 20-Dec-2007 PUT Option, I'd have to own around 9 of these PUT option contracts to offset the losses on my portfolio entirely below the 5500 level. I've started out by buying just 3 contracts today, as the market still seems to have upward momentum, and I might be able to buy additional contracts in future at a lower price (or ones with a higher strike price for the same cost). The three contracts will cost around 3*1,000*1.60 = $4,800 plus $100 brokerage. This equates to an "insurance premium" of 1.87% of my current equity. These contracts will reduce my losses below the 5500 level by around 1/3:

Full coverage for losses below 5500 up to 20-Dec would cost three times this amount (ie. 5.61%), so this strategy isn't sustainable indefinitely.

I'm only doing it now as the market seems to have reached dangerously high levels, plus the fact that I don't want to sell off significant holding and realise capital gains this tax year. I expect to start selling off some of my stock holdings after 1 July to reduce my gearing and start shifting my equity investments into a self-managed superannuation structure. This will mean that by the time the PUT options expire in December I won't have much of a geared exposure to shares (you can't directly use gearing within a superannuation account), and may have diversified some of this investment into other asset classes (eg. foreign stocks, commercial property, bond funds).

We'll see how this works out over the next 6-10 months.

I continued to build up my "Little Book" portfolio of US stocks with my regular US$5,000 stock purchase of one of the stocks listed by the magic formula investing website. This month I chose Crytologic (CRYP) . Some of my previous picks have dropped considerably, especially OVTI, so my overall portfolio now has around 0% return after deducting buy/sell costs. Taking into account the interest on the money I've borrowed to make the stock purchases, I'm under water at this point. Not that it really means anything - I plan to stick to my investing plan for at least ten years before looking at the average return and volatility to decide if the risk-adjusted return is as expected.

Aside from moving to dedicated hosting fairly recently, No Credit Needed (NCN) has now started to create an individual page for each member. I haven't updated my debt figures for last month yet, but as soon as I do (and NCN sets up my 'homepage' I'll put a permlink to my graph next to my NetWorthIQ chart (If I can display the chart as a link to NCN, rather than just a text link I'll do so).

Most of the NCN members are paying down CC or student loan debt, and hope to pay it off in a couple of years. If you're in a similar situation you can visit NCN for inspiration. Some other members are tracking more hefty debts such as home or investment property mortgages. I think I'm the only one tracking a whole portfolio of debt (mortgages, margin loans etc.) with a "pay off" timeframe of 20+ years!

While asset allocation is probably the most important factor in your long term investment performance, and fees and charges the second mosst significant item, the interest rate you pay on any investment borrowings are also a major consideration. A few percentage points extra can mean the difference between the use of gearing adding to or reducing your ROI. There can be considerable differences in the interest rates charged by different lenders, so it pays to shop around. Also, there may be price breaks from larger loan balances, so this is a time when diversifying between different lenders can be counter-productive. My investment borrowings are a bit of a mish mash, due to changes in investment stratgey over time, and using new lenders (at cheaper rates) for new investments, while keeping the old accounts in order to not realise capital gains just by shifting assets between accounts.

My investment loans:
Property
$230,602.65 @ 7.37% - home loan (non-deductible) - variable rate
$118,250.00 @ 7.09% - rental property loan (deductible) - fixed rate (5 yr term)
Shares - AU - three margin lending accounts
$19,474.16 @ 8.85% - St George Margin Lending (St George Bank) - variable rate
$12,042.90 @ 8.90% - Commonwealth Securities (Commonwealth Bank) - variable rate
$82,065.38 @ 7.95% - Commonwealth Securities (Commonwealth Bank) - fixed rate (1 yr term)
$150,000.00 @ 8.25% - Leveraged Equities (Adelaide Bank) - fixed rate (1 yr term)
$5,607.76 @ 9.15% - Leveraged Equities (Adelaide Bank) - variable rate
Shares - US
$59,175.20 @ 7.09% - St George Portfolio loan (secured against property) - variable rate
Other
$ nil @12.99% - Citibank*
* This Line of Credit is used to capitalise margin loan interest prepayment in June, and is then paid off with my tax refund in November.

Overall, the interest rate on my property loans currently averages 7.275%, and the interest rate on my stock portfolio loans currently averages 8.041%. The use of 1-year prepaid interest fixed rate loans helped lower the overall interest rate, as the Reserve Bank has raised rates a couple of times since June. The opportunity cost of prepaying interest for a year can be ignored as prepayment brings forward the tax deduction for the interest payment.

Gearing refers to the use of borrowings against equity to invest. It is calculated by dividing the total liabilities by the total assets.

I had a recent comment asking what level of gearing I thought was appropriate, especially for a 30 year old. Just to reiterate, I'm not a financial planner, so my thoughts are worth what you pay for them - nothing! And you should either make up your own mind after sufficient research, or go get some professional advice.

Having said that, many people have no qualms about borrowing 80% to buy a new home (gearing of 80/20 = 400%!), yet will be totally against any borrowing to invest in other assets such as shares. My views are
1. Gearing can be good to "convert" taxable income into tax-deferred capital gains when the tax-deductible interest you are paying on the loan is more than the investment income (eg. dividends) and IF it is deductible against other income (eg. wages), which is the case in Australia. Also, in case of Australia, capital gains get taxed at half your normal marginal tax rate if held more than 12 months.
2. Gearing should be against a diversified portfolio, NOT one or two "hot" stocks.
3. You must have a sufficient and secure income to cover the interest costs - don't just rely on dividends to meet the repayments (although if you only gear up to 50% or so your dividends may cover the interest costs - this is called "neutral gearing")
4. You should gear conservatively - for example if a share portfolio can be geared up to 70% LVR (about 225% gearing), you shouldn't gear up to the maximum. Generally I only gear up to 100% (a 50% LVR), so the market would have to drop considerably before I'd be worried about getting a margin call.
5. Have other assets and savings that you could use to meet a margin call. Ideally you should be in a position to buy more shares in the bottom of a bear market, not have to sell off your portfolio to avoid a margin call.
6. If you have lots of equity in your house you might consider borrowing against it to invest in a diversified share portfolio or, say, index share fund. This would be a viable alternative to using your real estate equity to borrow and buy a rental property (which many people do). I aim to balance my property assets (house and rental property) with my stock investments (direct stock portfolio, mutual funds and my retirement account investments).

This all assumes you have a high risk-tolerance like me. You really have to know your own risk tolerance before you can even consider gearing as an investment strategy. I'd suggest investing just your own capital to start with, and wait and see how you react to the first real bear market (-25% to -40% or more) before thinking about gearing. For many people gearing is TOTALLY INAPPROPRIATE as it doesn't match their personality, experience, knowledge, requirements or situation.

Debt Update: as at 31 Oct 2006

My updated debt data will be on NCN soon. My debt balances as at 31 Oct were:

property |- $199,813.62 Inv Property a/c #1
|- $350,577.18 --- $263,442.68 Inv Property a/c #2
| (x 0.5) |- $237,898.05 Home Loan
|
-- $685,362.34 --- $334,785.16 --- $ 52,937.16 Portfolio Loan
| "good" debt stocks etc |- $ 19,404.57 Margin Loan a/c #1
| |- $ 94,108.28 Margin Loan a/c #2
| |- $155,585.68 Margin Loan a/c #2
| |- $ 11,749.47 Line of Credit a/c
|
$683,127.44 --+ $2,234.90 ----- $ 15,765.10 -- +$ 1,724.90 Cr Bank #1 VISA
TOTAL CCARDS | |- $ 11,760.00 Bank #2 MasterCard
|- +$ 18,000.00 |- $ 5,730.00 Bank #3 MasterCard
0% bal xfer
(invested)

Major changes in debt this month:
- increased Outstanding Portfolio Loan: $10,000 for purchase of T3, and $6,000 for monthly addition to "little book" US share portfolio
- increased Outstanding Property Loans by redraw of $6,000 to cover this month's property loan repayments while wife is on maternity leave
- increased Outstanding Margin Loans by regular gearing plan $100
- decreased balance xfer CC debt by min payment amounts of $375
- decreased Outstanding Citibank Line of Credit by $3,000 payment

Net change:
- total debt increased by $9,875.73 (1.47%)

personal finance, investing, money, debt

Using gearing to increase your returns in the long term has a couple of problems:
1) The interest rate charged directly impacts on the extra return generated
2) The extra risk (volatility) generated by gearing is large compared to the extra return

To get a better feel for how good a strategy gearing is, I've first looked at the current interest rates available for margin loans (and how it depends on the amount borrowed) and the current spread between the margin lending interest rate and the target cash rate set by the reserve bank.


The graph shows that the interest rate charged on a margin loan varies considerably between the different margin lenders, so it pays to shop around. Generally, the interest rate is reduced for clients with a large loan balance, so it's probably worth having one large loan rather than spreading it between several lenders (this is something I need to fix over time, as I currently have three different margin loan accounts. The problem is the tax effect of realising capital gains when transferring holdings from one lender to another).

It can be seen that the current spread between the target cash rate (6.00%) and the typical margin loan interest rate on a $500,000 loan is about 2.5% - so I've assumed this was the typical spread during the past ten years or so.

I've then used the changes in the target cash rate over the past decade (see below) to calculate the average margin loan interest rate each year since 1997, and compared that to the change in the All Ordinaries Index each year:
Average ----with gearing----
Year cash ML XAO XAO % % gain w/out 50% LVR 67% LVR
rate rate start end change or loss ML 100% D:E 200% D:E
1997 5.48% 7.98% 2411.2 2609.1 8.21% 0.23% 8.21% 8.43% 8.66%
1998 4.98% 7.48% 2609.1 2832.6 8.57% 1.09% 8.57% 9.65% 10.74%
1999 4.79% 7.29% 2832.6 3124.1 10.29% 3.00% 10.29% 13.29% 16.29%
2000 5.93% 8.43% 3124.1 3205.4 2.60% -5.83% 2.60% -3.22% -9.05%
2001 5.06% 7.56% 3205.4 3384.5 5.59% -1.97% 5.59% 3.61% 1.64%
2002 4.56% 7.06% 3384.5 2996.2 -11.47% -18.53% -11.47% -30.00% -48.53%
2003 4.81% 7.31% 2996.2 3309.8 10.47% 3.16% 10.47% 13.62% 16.78%
2004 5.25% 7.75% 3309.8 4060.7 22.69% 14.94% 22.69% 37.62% 52.56%
2005 5.46% 7.96% 4060.7 4721.1 16.26% 8.30% 16.26% 24.57% 32.87%
AVG 8.13% 0.49% 8.13% 8.62% 9.11%

This table confirms that the use of gearing would have boosted your returns during the past decade - from an average of 8.13% pa without gearing, to 8.62% using 100% debt:equity (a 50% loan:value ratio), and 9.11% using a higher gearing rate of 67% LVR (close to the normal lending limit of 70%).

However, it also clearly shows that the use of gearing greatly magnified the ups and downs of a portfolio - the relatively modest 11.47% drop during 2002 would have meant a 48.53% drop in value of a portfolio using 67% LVR, and probably would have required more cash being added into the account to avoid getting a margin call.

In the long term, getting a return of 9.11% instead of 8.13% will have a large effect on your final net worth - if inflation averaged 3% this would result in a real return of 6.11% rather than 5.13% (an improvement of 19%).

It is important to watch your LVR when using gearing, be conservative when the market is setting new highs, and be prepared to manage your portfolio to avoid any margin calls. It is also very important to shop around for the best possible interest rate - possibly using home equity to obtain lower rates.


personal finance, investing, investment, stocks

How can you use gearing as part of your investment strategy? I hope to increase the returns of my portfolio with the least possible increase in risk by using borrowed funds to increase my investment. A simple example would be to invest a total of $200,000 in an index fund (eg. Vanguard) via a margin lending account, so that you've put in $100,000 of your own savings, and have borrowed the other $100,000 from the lender. The income from the $200,000 investment would cover part of the interest on the borrowed $100,000. Any extra I have to kick in from my cash flow to cover interest payments is tax deductible.

I prefer this approach (use of gearing) to that of boosting returns by including more risky assets in my portfolio because, theoretically, using gearing can provide more increase in return for an increased level of risk than just including a larger proportion of high-risk, high-return assets in your portfolio. Apparently it has something to do with the tangent of the line from the interest rate on the borrowed funds to the point on the efficient frontier corresponding to your asset mix having a steeper slope compared to just moving along the efficient frontier... Don't ask me to explain! As far as I can tell it looks something like the diagram below:


The idea is that you can increase the return of your "efficient" portfolio more by taking on extra risk through the use of gearing (ie. along the red line) than by changing the asset mix to include more risky assets (moving along the efficient frontier, assuming you have the right asset mix).

I don't worry too much about the details, as the entire concept of the efficient frontier seems fairly academic. In practice, you don't have precise data about all the assets in your portfolio (historic standard deviation, return, and covariance for all of the assets in your portfolio) or for determining the efficient frontier (such data on all possible assets mixes). Also, the usual problem of predicting the future using historic data applies. In practice, it seems that a sensible, well-diversified asset mix lies pretty close to the efficient frontier, and the use of gearing will be preferable to the inclusion of more risky assets in your portfolio (provided the interest rate on your investment loan isn't too high).

The other benefit of using gearing is that by having a larger total investment you are more able to make use of diversification.

Several things about the use of gearing (borrowing to invest) seem important to me:
1. You have to manage your risk - it is stupid (very risky) to borrow to invest in just one particular stock, or sector (eg. tech, oil, bio etc). I was amazed to learn that around 15% of margin loans are for accounts that have only one stock in them! The chances are you are not the next Warren Buffet (I know I'm not), so it's much more sensible to diversify - either via a portfolio of at least 10-12 stocks (not all in the same sector), or else via an index fund. Or a combination of both.
2. You have to borrow at the best possible interest rate - over time I've opened new margin lending accounts with lenders that offer a lower interest rate and that allow you to trade on your margin account via an online discount broker. Interest rates may be lower if you borrow a larger amount. I also have a margin lending account with the bank that provided my home and investment property loans - as a preferred customer I get 0.25% knocked of the standard interest rate. Most recently I used a "portfolio loan" secured against the equity in my real estate assets (similar to a HELOC?) to borrow at the standard home loan rate and invest in a portfolio of US shares (see my posts about my "Little Book" portfolio).
3. You should borrow less than the maximum so that you have a buffer against getting a margin call when the next market correction/bear market/crash happens. If the average margin for the stocks in your margin lending account is 70%, then you probably shouldn't get your loan-to-value ratio (LVR) above 50%.

The table below shows what % drop in the market would trigger a margin call for different starting values of gearing:
Assumptions:
Average 70% margin
Margin Call occurs if loan > 105% of margin value

% drop to initial initial initial
Capital Loan Total get a call LVR MU DER gearing
$100,000 $ 50,000 $150,000 54.6% 33.3% 47.6% 50.0% 1.5
$100,000 $ 60,000 $160,000 48.9% 37.5% 53.6% 60.0% 1.6
$100,000 $ 70,000 $170,000 43.9% 41.2% 58.8% 70.0% 1.7
$100,000 $ 80,000 $180,000 39.5% 44.4% 63.5% 80.0% 1.8
$100,000 $ 90,000 $190,000 35.5% 47.4% 67.7% 90.0% 1.9
$100,000 $100,000 $200,000 31.9% 50.0% 71.4% 100.0% 2.0
$100,000 $110,000 $210,000 28.7% 52.4% 74.8% 110.0% 2.1
$100,000 $120,000 $220,000 25.7% 54.5% 77.9% 120.0% 2.2
$100,000 $130,000 $230,000 23.0% 56.5% 80.7% 130.0% 2.3
$100,000 $140,000 $240,000 20.6% 58.3% 83.3% 140.0% 2.4
$100,000 $150,000 $250,000 18.3% 60.0% 85.7% 150.0% 2.5

LVR = loan-to-value ration (amount borrowed / total value of portfolio)
MU = margin utilisation (amount borrowed / max. amount allowed)
DER = debt-to-equity ratio (amount borrowed / your equity)
Gearing is basically the "muplitplier effect" that will apply to any losses or gains made by the portfolio on your equity. For example, if the gearing used is 2.0, then if your portfolio went up 10% your equity will have increased 20%. Similarly, if the market "corrected" -15% causing your portfolio to drop -15%, your equity will have gone down by -30%.

As the loan amount stays constant, any drop in the value of your portfolio will decrease the margin value (eg. 70% of the portfolio value). This also means that your margin utilisation increases. Most lenders will give you a "margin call" if your margin utilisation exceeds 100%. (There's often a "buffer" of 5%, so you'd get a margin call if the MU was >105%). When you get a margin call you have to bring your MU back down to less than 100%. This can be done in several ways:
* put some cash into your account (ie. pay off some of the loan) - this is best
* put in some stocks (eg. if you had some unencumbered stocks you could add into the margin account) - this is second best, as only the margin value of the stock (say, 70%) counts.
* sell off some stocks - you may not want to sell at the price prevailing when you get a margin call.

The most interesting column in the table is the % drop required to trigger a margin call. Looking at daily closing price data for the Australian All-Ordinaries Index (similar to the S&P500), I calculated the maximum % drop ever experienced after buying on any particular date for the past ten years. This period doesn't include any once-in-a-lifetime crash like '87 or '29, but does include the major bear market of the early noughties. I then grouped all the maximum decreases into bands - for the 2,531 days studied (1996-2006) I counted how many times the maximum drop was 0-5%, how many times it was in the range 5-10 % and so on. The tabulated results are:
max drop count probability
0% - 5% 1,069 42.2%
5% - 10% 438 17.3%
10% - 15% 480 19.0%
15% - 20% 439 17.3%
20% - 25% 105 4.1%
25% - 30% 0 0.0%
30% - 35% 0 0.0%
35% - 40% 0 0.0%
>40% 0 0.0%

TOTAL 2,531 100.0%
This shows that, at least for this past ten year period, if you'd invested on any randomly selected day for had a small (4.1%) chance of experiencing a drop of 20-25% before things began to improve.

You had a much bigger chance (21.4%) of experiencing a drop of over 15%. And drops of less than 15% are quite common.

This emphasises why it is important not to use excessive gearing - you have a significant liklihood of getting a margin call if your LVR is much over 60% (remember, an 18.3% drop will trigger a margin call if your LVR was 60%). Using gearing conservatively (say less than 50% LVR) with a well-diversified portfolio reduces the chance of a margin call significantly.

My plan is to maintain an LVR of around 50%, giving me a gearing ratio of 2. Assuming I can borrow funds at around 7.5% on average, and my portfolio return averages around 9.0%, I would expect my return on equity (ROE) to be 9.0% + (9.0% - 7.5%) = 10.5%. Assuming inflation averages around 3.0%, this extra 1.5% return would mean my real (after inflation) return is increased by 33% using fairly modest gearing. And this would have a big impact on the final balance.

NCN is an interesting blog that gathers and reports the progress of various bloggers that are attempting to pay down their debts. Most of the participants have student loans and/or credit card balances that wish to eliminate as quickly as possible, but there are also a few reporting on home loan and business loan balances. I thought I may as well track the total quantum of debt I am carrying using this site to keep track of how much I ower and my progress paying off my home loans.

While I have no student loan balance* and pay off my "day-to-day expenses" credit card charges in full each month. I have some other credit card accounts which I recently opened and have taken out 0% balance transfers to invest in an online account and earn some interest on OPM^ [see previous posts link, link, link, and link] . I also have home loans for my house and an investment property which I aim to pay off in 10-15 years. My other main debt is margin loans from several lenders for my Australian and US stock investments, some mutual funds, index funds and hedge fund investments. These are generally "interest only" loans - indeed I generally capitalise a "pre-payment" of 12 months interest at the end of each tax year (to bring forward the tax deduction on the interest) and then pay off the capitalised interest over the following 12 months. I also expect to increase my margin loan balances over time as my stock portfolios appreciate - my aim is to keep the loan-to-value (LVR) ratio of my margin loans at around 50%-60%. As the stocks and funds in my margin loan accounts typically have a margin value of around 70%, this keeps my margin utilisation around 70%-85%. The margin lenders allow you to reach 105% margin utilisation before a margin call will result (when you have to reduce your margin utilisation back below 100%). This allows for an overall drop in the value of my portfolio of around 18% without getting a margin call.

I'll be sending updated figures to NCN each month and posting a link to the updated graph each month.

Debt info: (Sept)
|- $200,598.09 Investment Property a/c#1
|- $348,235.52 --- $258,020.14 Investment Property a/c#2
| (x 0.5) |- $237,852.82 Home Loan
|
-- $669,719.09 --- $321,483.57 --- $ 36,850.28 SGPL
| "good" debt margin loans |- $ 19,325.00 SGML
| |- $ 94,108.28 Comsec
| |- $155,592.50 LE
| |- $ 15,607.51 Citibank
|
$673,251.71 --- $3,531.62 ----- $ 15,532.62 -- +$ 2,332.38 Cr NAB
TOTAL CCARDS | |- $ 12,000.00 Virgin
| |- $ 5,865.00 Coles
|- +$ 12,000.00
invested Cr


* In Australia we pay only a portion of the total cost of our studies, known as HECS (higher education contribution scheme). It can be accumulated as a debt to the tax office, and gets automatically paid off via a tax surcharge once your income reaches a threshold level. Alternatively you can pay the HECS "up front" and get a 15% discount on the amount you have to pay. I've always paid my HECS "up front" so I have no debt from my studies.

^ Other peoples money - I love credit card companies lending my their money at 0% for 6 months.

personal finance
money
saving

The SMH (Sydney Morning Herald) had a good article "Eased tax rules tempting more into margin loans" that summarises the benefits and risks of gearing into share investments via a margin loan.


"...153,000 brave souls [are] now leveraged against the stockmarket."

"The concept of negative gearing is relatively simple. It's "gearing" because you borrow money to buy a bigger portfolio, pocketing the full benefit of any after-tax capital gain.

It's "negative" because it's designed to run at a loss, which you can claim each year as an offset against your income from other sources to reduce your tax burden."

"The end of the housing boom has sparked a hunt by investors for the next pot of investment gold."

"While the median price of houses in Sydney has fallen 8.5 per cent since peaking in December 2003, the sharemarket has surged more than 50 per cent."

The main benefit of negative gearing is that you are able to convert income taxed at your marginal tax rate, into capital gains, that are taxed at a reduced rate:

"Back in 1999, the Federal Government halved the tax on capital gains for assets held for more than 12 months."

However, gearing into shares is more risky than borrowing to invest in real estate, due to the possibility of getting a margin call if the market slumps:

"After falling pretty steadily for the last two years, the average number of daily margin calls doubled in the June quarter, from one in every 4000 accounts to one in 2000.

A margin call is particularly devastating because as a consequence shares are often sold at depressed prices, magnifying losses."

Canadian Capitalist has a post about the "Smith Manouevre" - basically just paying off your undeductible home loan as quickly as possible, and simultaneously borrowing to invest in the stock market. Apparently there has been "a fair bit of discussion going on about The Smith Manoeuvre (SM) in Jonathan Chevreau’s columns in The Financial Post and on his Wealthy Boomer Blog"

I wasn't even aware that this basic idea had been given a name!

Canadian Capitalist goes on to say "I doubt that there is a causal link between leveraging and wealth and what wealthy people do after they have accumulated assets is immaterial to the argument.

Personally, I want to keep things simple. Sock away the maximum possible in a RRSP" [retirement account] "and pay down the mortgage with the rest of the savings. The way I see it, I can earn a guaranteed, risk-free, after-tax return of 5.25% (our mortgage interest rate) by paying down the mortgage, which I think is pretty darn good."

I generally like what CC blogs, but I didn't realise he was so conservative an investor. Sensible levels of tax deductible debt to invest via gearing (eg. into a rental property, or diversified stock portfolio) is a well accepted method of improving your investment returns. If you use the extra amount invested to increase your diversification you can even boost your returns without increasing risk (variability of returns).

One thing I that I don't like about gearing is that the interest rates are generally 1-2% higher than those available for investment property loans (which are the same as for a home loan). These days I'm trying to reduce the average interest rate I'm paying for my investment loans, by only adding to my leveraged portfolios with the margin lender that has the lowest rate, and also doing my direct US share investments using funds from a St George Porfolio loan - which is secured against my equity in my home and investment property, so is at the same rate as a home loan.

Gearing can have significantly improve your portfolio performance over time - for example, if an ungeared, diversified portfolio of local and international shares, property, bonds etc. returns as average of 9% pa, you borrow to invest at an interest rate of 8%, and you gear 100% (LVR of 50%), you would improve your ROI from 9% to 10% - over 20 years this would mean a $100,000 portfolio had a final value of $611,000 rather than $514,000 - an improvement of 18%!

What I would like to do one day is compare the average interest rate charged for margin loans (I think it's around 3% above the cash rate, but I'll have to check the current average interest rate vs. cash rate and look at the past 10 years figures to see how consistent this is) vs. the average return on a range of typical portfolios eg. conservative, balanced (cash/bonds/stocks/property), and somewhat aggressive. I suspect gearing is only worthwhile if your risk tolerance allows you to invest aggressively, as the return on a conservative portfolio would probably average less than the interest being charged on a margin loan.

One of the unsung benefits of using gearing is that it provides a means to reduce taxable income (eg. dividends, rental income, wages) by providing a tax deduction for the margin loan interest, and effectively converts this into capital gains which are tax deferred (until the CGT event eg. sale) and ultimately gets taxed at only 50% of your marginal tax rate (if you hold the asset > 12 months). Of course, the main reason for gearing should be to boost your long term ROI, not to reduce your tax bill!

With the recent changes to superannuation taxation, gearing is probably less attractive compared to salary sacrificing into superannuation, but it doesn't have as much legislative/political risk as super.

Personal finance, Money, Investing, Investment, Wealth.

If you want to boost your investment returns, are comfortable taking on increased risk, have adequate resources to ride out any market downturns, and are investing for the long haul, then perhaps gearing is for you. Then again, maybe not. Reminder: This Blog is NOT financial advice

The concept of margin lending is pretty simple - you buy some shares of mutual funds using some of your own money plus some money borrowed from a margin lender. Each share and fund is assigned a margin, which is the maximum percentage that will be lent against that security. Once you have a few securities in your margin lending account, the overall margin of the account determines how much your total loan can be. The "margin value" of your account goes up and down with the prices of the securities, so if you borrow close to the maximum and the market tanks, you'll get the dreaded "margin call" - which means that you have to bring your loan balance back within bounds. This can be done by adding in some more funds or securities, or selling some of the securities in your account. So it's a good idea to be conservative in your use of gearing (eg. use only 50% when the limit is 70%) and to have some funds to draw on in a real crash(eg. some redraw available from your home loan account). [One of the most infuriating features about using gearing is that when the market crashes and you keep your nerve and are dying to pick up some "bargains" is exactly when you're most likely to hit your margin limit and can't afford to borrow any more!]

Over the years I have moved my mutual fund and direct shares investments into margin loan accounts with three providers - Leveraged Equities, Comsec and St George Margin Lending. Although the basic product is similar, there are differences that set them apart and can be important.

A general comparison of available margin lenders can be found on infochoice.

I started out with ungeared share investments, then transferred my holdings into a margin lending account with Leveraged Equities. They have been around longer than most, and nowadays are owned by Adelaide Bank - not that they offer any sort of guarantee! Leveraged equities has a minimum loan balance of $20,000 - you can start off with less, but you'll still pay interest on $20,000.
Pros: They have an default loan limit of $1,000,000 but you don't have to get approval for a specific amount and they don't need your income details. They really do secure the loan only against the underlying securities (but you'd still owe them the balance if a market crash left you with no equity). This is different from Comsec and St George which have to approve a particular limit, based on your income ad other assets and debts when you apply. You then have to apply if you need an increased limit later on. Another nice feature is that you can transfer funds easily to and from your nominated bank account and the margin loan account. This can be handy if you want to borrow funds to invest in some other investment eg. An agricultual scheme. Beware: if you used the funds for something else (eg. paying off your car loan) the interest on that part of the loan balance wouldn't be tax deductible, which would make the paper work way too hard.
Cons: You can't trade directly, online - you have a broker linked to your margin account and trade through them. This means you have to trade by phone and tell your broker that the trade is on your margin account. Also, the interest rate is generally a bit higher than some other lenders.

Comsec: My second margin lender. I opened this account as you CAN trade on your Comsec Margin account via the internet, which is cheaper and, for me at least, is less hassle.
Cons: One feature I hate is that you have to have separate accounts if you want to trade options or overseas shares. In an ideal world you could do it all within the one account - they'd just assign zero margin limit to such securities. They also charge a $10 "transfer fee" to settle your online trades via the margin account, which seems a real ripoff as you are making the trade online from within the margin account! It makes the online trades less economical for small parcels.
Pros: You have your loan details, contract notes and access to research all within the one online account.

St George: Similar to Comsec, but, as a "Gold" customer (due to having my home loans with them) I can get a small discount off the standard margin loan interest rate. But you have to ask for it, the margin lending group seems to work quite independently of the rest of the bank. eg. Your margin loan doesn't appear with your other accounts when you do internet banking with St George. This seems a bit strange, especially when you have a "Portfolio Loan" with the bank.
Cons: As with Leveraged Equities, you have to trade via your broker, which is not ideal. You also get assigned a set loan limit when you open the account, so you have to apply if you want to increase the limit later on.

All three margin lenders have lists of "approved" securites that they'll lend against, and may differ in the margin limit assigned to each security. This may matter if you already have some shares you want to lodge as security. Their interest rates differ a little bit, with the banks usually a bit cheaper on the variable rate compared to LE. You can prepay the interest on a portion of your loan balance (up to 12 months in advance is tax deductible at the date it is paid) - the rates on offer can differ quite a lot, so it pays to compare rates.

Some drawbacks of having multiple margin accounts:
* The holdings are each under a separate HIN, so if you have the same secuity in two accounts you'll get two dividend payments, annual reports and so on.
* The margin utilisation is calculated individually for each account, and it's not practical to shift funds from one lenders account to another.
* You get multiple monthly statements, and have a bit more paperwork at tax time.

As their are no account keeping fees there's really no cost in using more than one margin lender.

If you're aything like me, incorporating the level of risk that you believe you're comfortable with into your asset allocation could still result in unpleasant surprises in the long run.

I've often read that for the long-term investor, time heals all wounds - that is, while equity investments may have large year-on-year variation in performance (a.k.a. "risk"), over long periods of time this variability "evens out" and the long-term performance will display less variation. That is, "risk" decreases over time.

However, I'd recently read a contrary view (unfortunately I can't recall the reference) which stated that time won't decrease the amount of variation (in dollar terms) in your final outcome. This seems to be at odds with the generally accepted view, but in fact it is just a different way of looking at the expected results - concentrating on the variability in the final dollar value of your portfolio rather than in the percentage average return overall.

While it is true that over time the average return will tend closer to the expected long-run value over time, this does NOT mean that in the long run your portfolio will end up with a final value close to what you thought you could reasonably expect. Due to the effect of compounding, over longer time horizons even small variations in average return have a big result.

Even though I was aware of this fact (and have an understanding of the "magic of compounding") it really didn't hit home for me until I ran some simulations of my portfolio (using my current investment mix and projected returns and std deviations loosely based on data from Portfolio Solutions)

It turns out that while the most likely outcome is as I'd expected (around $3 million AUD by the time I retire around 2027), there are several "outlier" scenarios where the end value of my portfolio would be less than $1 million - which is pretty depressing compared to my current net worth and what I could achieve by just investing the entire portfolio in "safe", fixed interest assets! Of course, with my current portfolio mix there is a similar probability that I could end up with over $5 million.

Before we look at the results of my modelling (done in excel) I should point out that it was a bit rough and ready. I had to use guestimates as to reasonable return and std deviation values to use for my "alternate" investments (gold, agribusiness trusts, coins) and "hedge" funds (OMIP series and Macquarie Equinox Select Opportunities). For the other asset types I adapted the values listed by Portfolio Solutions. Because I didn't have any information on covariance between by investments I've lumped all assets of the same class together (ie. All Australian share holdings are lumped together as one total amount, combining my superannuation funds, direct share holdings and geared share fund investments in my model). Hopefully any covariance errors should largely cancel each other out - lumping the like investments together assumes a covariance of "1", whereas they would really have a value slightly less than "1". And the model also generates each years return for each different asset type independantly, based on the asset types return and std deviation values and the amount invested at the start of the year (see this site for an excel formula that can be used for modelling normally distributed returns using mean and std deviation values). This means that the different asset classes have an implied covariance of "0", when in fact some would have a covariance value in the range 0-1 (eg. Australian and International shares), and some of the others would have negative covariance values. According to MPT by having a mix of assets my total portfolio should have significantly less risk than shown in the model. But this is still good as a "worst case" scenario. If I get in the mood I may attempt to calculate return and risk values to use for my Hedge and Alternate investment classes using the monthly unit price data I have for OMIP funds etc.

I think the main take-home lesson from this exercise is to remember that ANY one of the projected scenarios is equally likely to happen, but that you'll only get one bit at the cherry. So you could end up with one of the less likely outcomes - either very good or very bad. While looking at average results and the most likely outcome is useful for planning purposes, if you are taking on increased risk in order to achieve higher returns, you have to have a hard look at what the end result could actually be, and be comfortable with whatever happens. Que Sera, Sera!

Table 1: My current Portfolio Asset Mix


ASSET Gearing Annual Expected Performance
Type PV % Mix (Loan) Addition LVR Return Risk (std dev)
Au Shrs $595,596.00 34.5% $262,719.20 $ 8,299.35 44.1% 8.00% 17.00%
Int Shrs $232,864.00 13.5% $ 92,572.80 $ 6,453.95 39.8% 8.00% 15.00%
Au Prop $761,770.00 44.1% $350,554.00 $13,559.70 46.0% 7.50% 14.00%
Hedge $ 88,100.00 5.1% $ 57,620.00 $ 0.00 65.4% 11.00% 20.00%
Fixed Int $ 2,770.00 0.2% $ 554.00 $ 0.00 20.0% 5.00% 3.00%
Alternate $ 44,500.00 2.6% $ 0.00 $ 0.00 0.0% 3.00% 3.00%


Excel Formula for calculating a random return from an assets expected return and standard deviation:
Rn = SQRT(-2*LN(RAND()))*COS(2*PI()*RAND())

Figure 1: A plot of two runs of the model showing the degree of variability over time.


Figure 2: A plot of the first 32 out of 200 simulations.


Figure 3: A histogram of the end value of my Portfolio in 200 simulations.

The efficient frontier is a nice idea that actually makes a lot of sense - for any particular level of risk there is a maximum expected return that can be achieved. The efficient frontier is found by plotting the risk and return for the universe of all possible combinations of assets that you want to include in your portfolio, and joining the dots of the ones with the highest return for a particular standard deviation.

[graphic from styleadvisor.com]

For a good explanation of this see www.efficientfrontier.com or read this chapter from "Investment Strategies for the 21st Century" by Frank Armstrong [available free online!]

My difficulty is that my portfolio includes more than just equity funds, bond funds and fixed interest - I have direct property investments, alternative investments (agricultural trusts and hedge funds), direct share investments (local and US), and make use of leverage through property and margin loans. Aside from difficulty in calculating expected return and risk values for some of these investments, there doesn't seem to be much analysis of how gearing (the the risk associated with the loans) gets incorporated into modelling of the efficient frontier.

Wikipedia mentions that the use of leverage can actually lift you ABOVE the efficient frontier - but I'm not sure exactly why. To quote:
"An investor can add leverage to the portfolio by holding the risk-free asset. The addition of the risk-free asset allows for a position in the region above the efficient frontier. Thus, by combining a risk-free asset with risky assets, it is possible to construct portfolios whose risk-return profiles are superior to those on the efficient frontier.
* The investor who borrows money to fund his/her purchase of the risky assets has a negative risk-free weighting -i.e a leveraged portfolio. Here the return is geared to the risky portfolio. This combination will again offer a return superior to those on the frontier."

Unfortunately I haven't yet found a more detailed treatment of this elsewhere on the net. Also, in practice, your gearing uses margin loans or home equity loans at 2-3% above the risk free rate, so I'm not sure how this ties in with the presumption of leveraged investments utilizing the risk-free asset.

Any comments or references?