Success at the margin

we should learn why margin lending is changing and how to manage risks.

Borrowing to acquire a portfolio of shares or managed funds involves unique opportunities and risks compared to borrowing to acquire other income-producing growth assets, such as property. Many investors have learnt painful lessons about margin lending over the past six months.

As investors look for buying opportunities, it is worthwhile sharing the lessons.
Buffers and margin calls

Individual investors may take small comfort in knowing they were not the only one to receive a margin call for the first time. At least nine out of 1000 other investors recently received the same call each day.

The investors with silent phones were those with a gearing ratio below 50 per cent on a blue-chip portfolio that allowed a maximum loan-to-value ratio (LVR) of at least 70 per cent and 10 per cent buffer.

The first point to understand is that the buffer does not represent additional borrowing capacity even though it is often expressed as an addition to the LVR.
A simple example

Consider a $100,000 share portfolio geared to the maximum LVR of 75 per cent (a loan of $75,000) with a 10 per cent buffer. The investor’s gearing ratio can increase to 85 per cent (75 plus 10) before a margin call is triggered.

In dollar terms, the portfolio can fall to $88,235 ($75,000 loan divided by $88,235 portfolio equals 85 per cent) which is just under a 12 per cent fall in value. In this case, the investor will need to satisfy a margin call equal to at least $8824 to bring the loan back to 75 per cent of the current portfolio value by PUT IN YR MONEY TO KEEP 75% POSITION.

In other words, the investor must get their gearing ratio back below the maximum LVR, not just a point below the LVR plus buffer.

Take another investor holding the same $100,000 portfolio with only $60,000 borrowed. The portfolio could fall to $70,588, just over a 29 per cent fall, before a margin call is triggered. Let us assume disaster does strike and the portfolio falls by 30 per cent.

To bring the loan below the maximum LVR, the investor must meet a margin call of around $7500. The investor may look to reduce their gearing ratio back to 60 per cent in stages as funds become available.
LVR and liquidity freeze

Margin lenders spend a lot of time analysing the LVR they apply to a security. Yet for all this effort, the bulk of LVR falls within a narrow range of 50 to 75 per cent. Three key factors are considered: daily price volatility, liquidity and concentration of securities in the margin lender’s overall portfolio.

Notably, the LVR is not an indication of the likelihood of a particular security increasing in value over any given time.

Investors do not need complicated statistics to know that price volatility has increased dramatically. This has led to an across-the-board erosion in LVR, particularly for shares. Some LVR have increased and the most common LVR remains at 70 per cent.

However, the number of securities (both shares and managed funds) in the lower LVR ranges (45 per cent to zero) has increased over the past year. The main factor in this shift is liquidity.

The obvious example of a liquidity freeze is the managed funds that stopped redemptions. Liquidity risk is a very imprecise term and covers a number of interrelated scenarios.

Where there is one willing buyer at the willing seller’s price, then the asset may be considered liquid. If as a result of selling a parcel the price falls, then the asset is less liquid. Similarly, if the seller must spread their transactions over time to minimise the impact on prices, then the asset is less liquid.

Margin lenders will consider the total amount of any security held across all portfolios relative to the daily trading volume of that security. They will also consider an investor’s individual portfolio and may be comfortable with a mix of liquid and less liquid assets.

Small stocks under pressure

Small cap shares, for example, are more likely to have lower daily trading volumes. If the margin lender already has loans against such shares, then at some point the lender may become reluctant to increase their inherent liquidity risk and will reduce the LVR, at least for new loans.

The margin lender’s analysis is based on the worst-case scenario of having to sell part of the borrower’s portfolio to satisfy a margin call. A forced sale can result in a double hit for investors. The margin lender’s policy may require, for example, that the most liquid asset in the portfolio is sold first to satisfy a margin call. This is often a blue chip with the highest LVR.

It may appear counter-intuitive, but this policy is often in the borrower’s interest because the margin lender sells the least number of shares to satisfy the margin call. However, selling the asset with the largest LVR may affect the maximum amount that can be borrowed against the remaining portfolio.

This in turn will affect how much of a fall in value the remaining portfolio can withstand before a margin call is triggered. Also, it may not be the investor’s financial strategy to sell the blue chips, particularly in volatile markets.
Lessons learnt

Investors cannot eliminate the risk of a margin call but it can be managed. The first step for investors is to regularly monitor their gearing ratio to ensure it remains at a level that matches their risk appetite, financial objectives, and expectations about dividends and portfolio growth. If a margin call appears imminent, take action before it is triggered.

Second, investors may consider self-insuring against the event of a margin call. This involves progressively setting aside some cash, for example by capturing dividends, which can be used to meet a margin call. The level of cash required will depend on the investor’s gearing ratio relative to the portfolio LVR and their expectations about price volatility.

Over the medium term, shares continue to be an income-generating growth asset suitable for gearing by many investors. Shares and managed funds are divisible and on the whole remain highly liquid. This makes them more accessible to investors with moderate capital and offers diversification benefits for larger portfolios.

In this context and when combined with some common sense, risk-management margin lending can be no more complex than borrowing to buy property
SOURCES: Julie McKay is head of wealth products at Leveraged Equities.