The case for low-cost, protected gearing in a volatile equity market
A constant message from Alpha is: choose pre-June 30 investments on the basis of sound economic fundamentals and not just because they reduce tax.
Of course, we think Alpha POWER Shares Australia fits the bill on both counts.
Our innovative product has already paid a high income return of 13.55% (plus franking credits) net of fees in 2007.
And, subject to share market performance, POWER Shares Australia can return up to 21% capital gain per annum.
Interest is tax deductible and investors can borrow to pre-pay interest with the product – potentially creating larger upfront tax deductions. And although protected loans have been hammered in the May Budget – with big limits on the level of tax deductions that are available for interest costs (now limited to 9.35% deductions even though headline interest rates may be as high as 19% to 20% on a protected loan) – 100% lending into POWER Shares at rates around 10% means that there is very little impact to the levels of tax deductions available on gearing into POWER Shares.
Alpha believes there are five key messages around gearing before June 30:
A. Now is a good time to gear given the market sell-off and partial recovery
B. Investors must have portfolio protection given high market volatility
C. The traditional choice for investors has been protected equity loans
D. POWER Shares Australia provides the same benefits at around half the interest
E. POWER Shares Australia has outperformed the market and protected equity loans
Consider briefly each key message:
A. Now is a good time to gear given the market sell-off and partial recovery
The market sell-off at the start of 2008 was a brutal reminder on the dangers of unprotected, geared investments through margin loans. The 20% plus fall in the All Ordinaries index was magnified for those who borrowed to buy shares.
Despite the short-term volatility, gearing is still a critical investment strategy for many high-net-worth investors, not only due to the strategy’s tax benefits but also from the superior long-term investment record of Australian equities relative to other investment classes.
Leading advisers tell Alpha many clients believe “it is just too risky to borrow money to invest in the market”, are frightened by the prospect of margin calls, or simply do not have surplus cash to invest right now.
These are valid issues, but Alpha believes the opportunity to gear sensibly – with portfolio protection – into high-yielding, quality blue chips, is the best in at least three years.
See item two in this aMail for Alpha’s view on why a stronger recovery is ahead for the Australian stockmarket.
B. Investors must have portfolio protection given the high market volatility
Market volatility is at higher-than-average levels as this chart from the Reserve Bank of Australia shows:
Alpha believes investors must choose gearing products that offer portfolio “insurance” to safeguard their hard-earned investments.
It is simply too risky not to.
C. The traditional choice for investors has been protected equity loans
Most advisers typically recommend products such as protected equity loans (PELs) or geared equity investments (GEIs) that guarantee capital.
These products have their place, but they are costly and usually require large upfront cash outlays for interest pre-payments. Budget tax changes have made it even harder to use protected loans – but 100% investment gearing into POWER Shares has only been minimally impacted.
Current interest rates for PELs and GEIs are as high as 19 per cent!
After stripping out the (reduced) tax benefits and dividends, the breakeven return on these products is capital growth of almost double-digit rates, putting more pressure on portfolio performance.
D. POWER Shares Australia provides the same benefits at around half the interest
The interest rate on POWER Shares Australia is around 10 per cent – half the cost of many PELs and GEIs.
POWER Shares Australia:
- 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.
So why is the interest cost on POWER Shares Australia half that of its rivals?
The capital protection in POWER Shares is actively managed and low cost unlike the more expensive, one off cost of a simple put option which is embedded in the premium cost of a protected loan.
E. POWER Shares Australia has outperformed this year
POWER Shares Australia has strongly outperformed ordinary share investments in volatile markets.
POWER Shares Australia, the green line in the chart below, has also strongly outperformed other popular forms of capital guaranteed products such as PELs since inception.
