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Investing
With the market off by 25% this year and rates at over 10% - should you ditch that margin loan?
Fiona Harris - September 25, 2008
 If you are deciding whether or not to take out a margin loan, the answer comes down to one simple question - do you feel comfortable investing right now?
With interest rates as high as 10% and a volatile share market, margin loans would seem like an outside chance with most investors.
But according to Macquarie Investment Lending division director Peter van der Westhuyzen, while demand for the group’s margin lending product is lower than last year, it continues to be well supported particularly by investors who can spot the value in shares or managed funds.
“Interest rates have gone up but you have to think, interest rates might be higher but shares are down 25%. Dividend yields are higher too.” In other words, since dividend yields increase as prices come off, a margin loan – which is often funded by high dividend yields – still makes some sense.
But van der Westhuyzen says the existence of surplus funds should not be the main motivator for an investor to take out a margin loan.
Rather, investors should ask themselves given the current investment landscape, do they think they should invest, and if so, how could they fund that investment. “A pile of cash available in a bank account shouldn’t influence your decision whether to invest or not,” he says. “It just makes it possible.”
Investors also need to understand the risks associated with the investment. In the case of a margin loan, a margin call is generally regarded as the riskiest characteristic of the product.
A margin call is triggered if the value of your share portfolio falls too close to the value of the loan. To restore the buffer between these two values, your lender may ask you to invest more money, buy some more shares, or reduce the loan amount by offloading some of your investments.
All three courses of action can be scary, particularly if it is a situation for which you are unprepared.
St George Group’s general manager of margin lending David Curry says how you view the pros and cons of margin lending in the current environment depend on your individual circumstances.
“When do you buy stocks? When they are low and you sell when they are high. But a lot of people get scared by short-term volatility and sell stocks. But if you’ve got the head room, the same reasons apply.”
Indeed, this is one of the true benefits of margin lending. Since you are always invested, you are spared the dilemma of how best to time the market.
So while the value of your overall portfolio may decline with market fluctuations, the upside is - since you’re not jumping in and out of the market - you can take full advantage of the market upswing.
Curry says that it’s important investors truly understand the nature of margin lending before they invest.
“The fundamentals behind margin lending are it’s a long-term investment strategy and while you might get short term volatility, the fundamentals don’t change.”
He adds: “You need to be aware of volatility and you need to gear sensibly and diversify well. You need to think through if I do get a margin call, how would I deal with that?”
For an investor with an existing margin loan, the decision whether to hang onto it or not should have the same criteria as those looking at margin loans for the first time.
That is, am I still comfortable with my portfolio and is it still valuable?
“Again, you need to go back to the fundamentals of a long term investment,” says Curry. “If you believe there is good value in the market because it has come off some highs, the returns in the long term could be very good.”
Van der Westhuyzen says that the best way for an investor to decide if their investment is still profitable is to calculate the net after tax holding cost.
This is a calculation that takes into consideration a host of inputs including franked dividends and calculates the value of your investment net of costs. Financial advisers and accountants can help you work through this calculation.
Of course the best line of defence with a margin loan in trying investment conditions is vigilance. This means keeping track of the variables including interest rates, market volatility and share price movements.
And there are levers investors can pull to ensure that they’re comfortable with their investment.
“You might be comfortable with interest rates but not happy with the share price,” says van der Westhuyzen. “So you might lower your gearing levels.”
Ultimately good portfolio diversification, proper portfolio monitoring and erring on the side of caution with gearing levels should hold you in good stead.
“Most people are keeping gearing levels under control,” says van der Westhuyzen.
He says investors should also keep margin calls in perspective. “If you gear 50%, you need a 35% fall in the share price to trigger a margin call.”
More articles from this edition of CompareShares:
Bargain Hunting: How to find top stocks that are going cheap
Margin Lending: Rates up, sharemarket down – should you ditch that margin loan?
Adviser Lounge: Do I pay tax when rolling shares into a self managed super fund?
Economics: Worrying aspect of recent bank mergers
Financial crisis: RBA to help out global financial market
Global economy: World leaders fight financial crisis
Global economy: Eurozone economies on brink of recession
US Economy: World’s largest economy risks grinding to a virtual halt
Crisis: NAB may curb losses by tapping into US rescue fund
Future Fund: Aussie banks on radar for $64 billion future fund
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