Gearing strategies: the good, bad and very ugly
As the previous article shows, borrowing to buy shares is the best-performing investment strategy over the long run. But what is the best way to borrow?
Investors usually face these choices:
- Use the equity in their home to buy shares
- Use a traditional margin loan
- Use a protected equity loan
- Increasingly, use a structured product such as Alpha POWER Shares, which provides capital protection for about half the cost of protected equity loans.
Let’s briefly consider the pros and cons of the first three options:
A. Use the equity in their home to buy shares
Many high-net-worth investors have seen their property’s value rise sharply this decade – giving them more equity on paper. Why not use it to borrow to buy shares?
Pros
- Home loan interest rates are usually lower than margin loan interest rates
- There are no margin calls
- There is no restriction on shares that investors can buy using borrowed funds
Cons
- The strategy puts the family home at risk if loan repayments cannot be met
- There is less flexibility with repaying interest and principle
- A softening in property prices over the next 18 months makes the strategy riskier
- A better approach is paying off house debt as fast as possible as it is not deductible
Using home equity to establish gearing strategies normally does not work for “early accumulators” e.g. people in their 30’s to mid 40’s. The burden of paying school fees, mortgage/s and affluent lifestyles means many young people, including professionals, don’t have enough equity to get this type of gearing started. Something else is needed for this type of client.
B. Use a margin loan
With global stock markets firming slightly, margin loans can be used to snap up opportunities in beaten-up blue chips and higher-quality small stocks, right?
Pros
- Margin loans are much cheaper than protected equity loans
- They are a better strategy than using home equity to borrow to buy shares
- Investors can pre-pay interest upfront, bringing forward tax deductions
Cons
- Margin calls when gearing levels fall beyond acceptable levels
- Cannot borrow 100% of stocks – must have some equity to begin with
- Less borrowing capacity against shares outside S&P / ASX 200
- No protection against market falls: portfolios are unhedged
- Have to pick the right stocks and monitor them closely
One problem for potential investors who think about starting a margin loan is the need to find the 30% upfront equity required, as well as funding interest payments. In current markets, this means that it costs around $40 to start a margin loan facility over a $100 portfolio.
C. Protected equity loans (PELs)
Protected equity loans offer the benefit of borrowing to buy shares – but without the risk.
Pros
- Interest-only loans
- Capital guaranteed through the inclusion of put options
- Can borrow 100% of investment
- No margin calls – a more aggressive approach to stock selection can be taken
- In some cases, can cap capital gains in return for lower interest rates
- Limited recourse investment – can hand back shares and walk away
Cons
- Up to 8% dearer than a traditional margin loan
- Interest rates as high as 18% on some PELs are simply too expensive
- Less tax-effective for new investors after Federal Budget tax changes (see item six)
The three key messages are:
- Using home equity to buy shares is a dangerous strategy
- Using margin loans without inbuilt hedging is risky in volatile markets and expensive
- Using a PEL is less expensive than starting a margin loan but still requires a large upfront outlay.
More leading advisers are using 100% investment loans over Alpha POWER shares to overcome these problems.
In summary, Alpha POWER Shares:
- is capital guaranteed by UBS Bank AG
- lets investors borrow 100% of their capital outlay to invest in the product
- provides an interest-only loan that can be pre-paid for 12 months or monthly in arrears
- lets investors borrow the cost of their interest pre-payment by using an interest pre-payment loan.
- Has as interest cost around half that of protected equity loans: current borrowing rates for Alpha POWER Shares are around 10.25%
- Interest Prepayment Loans allow you to borrow the interest needed for your investment loan...this allows cash poor investors to start a gearing strategy for very low upfront cost.
To find out more about POWER Shares, click here.
