MARGIN LENDING
NOVEMBER 2013
Portfolio Diversification
and Protection
Throughout the journey of wealth creation, investors often come to cross roads and
face choices that could influence the success of their investments.
Using gearing to
maintain momentum
With each market rally comes the
wonder of how long this rally will
last. We take an interest in views of
analysts, economists and financial
advisers as they provide their insight
into answering, “Where to from
here?” As an investor, do you sittight or bank some of the profits?
Without the benefit of a crystal ball,
it is difficult to predict an exact
answer
however;
there
are
strategies to help investors avoid a
negative impact to an investment
portfolio. Here we provide two
scenarios about how margin lending
could work to keep you on track
with your wealth creation journey in
times of uncertainty.
Using gearing to
diversify a portfolio
Gearing into the share market,
commonly known as margin lending,
can prove to be a beneficial strategy
when used with a conservative
approach. Through gearing, an
investor can build a larger
investment portfolio, as well as
increase the income (and in many
cases franking credits) generated
from Australian shares, which can
help offset the costs of borrowing.
Margin lending also serves as a tool
to diversify a portfolio. By
borrowing to diversify, an investor is
not only reducing the concentration
risk in the portfolio, they could also
be saving on potential capital gains
tax if they were to sell existing
shares as a means for funding new
investments. The following case
study illustrates how gearing can be
used to diversify a concentrated
portfolio.
CASE STUDY
Assume an investor holds $100,000
in Company A and is concerned that
if the market begins to fall, their
entire portfolio is at the mercy of a
single security. Concurrently, the
investor is particularly bullish on a
number of other shares which they
believe are sound businesses and
solid investments. The investor’s
issue is all her investment capital is
tied up in Company A and to sell a
portion would result in a substantial
capital gains tax bill. The investor’s
financial adviser suggests using the
holdings in Company A as collateral
for a margin loan to borrow funds to
invest in the other shares. After
considering her circumstances, the
investor decides to establish a
margin lending account to expand
the portfolio. The figures below
compare the initial single security
portfolio and the expanded portfolio
using gearing.
In the example below, the client
borrowed $200,000 to purchase an
additional four securities. Both the
client and financial adviser were
comfortable with the gearing level
of 66%, as the client did not borrow
to the maximum, and is appropriate
to her circumstances.
As illustrated, Company A initially
represented 100% of the investor’s
portfolio. Using a conservative
gearing strategy, the investor
managed to reduce the concentration
of the initial security to represent
one-third of the overall portfolio.
Ungeared Initial Portfolio: Single Security
Security
Value
% of Portfolio
Company A
$100,000
100.00%
TOTAL
$100,000
100.00%
Geared Portfolio: Diversified Securities
Security
Value
% of Portfolio
Company A
$100,000
33.33%
Company B
$50,000
16.67%
Company C
$75,000
25.00%
Company D
$25,000
8.33%
Company E
$50,000
16.67%
$300,000
100.00%
TOTAL
Note: For the purpose of the illustration, we excluded margin lending interest, brokerage
and other fees and charges.
• Reduced exposure for the
concentrated holding and added
diversity with new securities
• Avoided the need to sell initial
holding to free-up capital, and no
CGT implications
• New potential gains from the new
securities are enhanced
• Potential
opportunity
for
dividends and franking credits
from the new securities
• Loan interest may be tax
deductible
STRATEGY RISKS FOR THE INVESTOR
Investing in other securities to
diversify an investment portfolio
increases the amount borrowed and
subsequent gearing level. The
investor must ensure they are
comfortable with the additional
interest cost due to the increased
amount which has been borrowed.
The investor should also remind
themselves of the general risks of
using gearing which are outlined at
the end of this document.
Portfolio protection
using Options
When most people consider which
assets to insure, the common
choices are the family home,
investment property, vehicle, boat,
jewelry and their health. However,
another important investment is the
share portfolio, which can be
insured by using options, in
particular Put options.
By purchasing Put options, an
investor has the right but not the
obligation to sell an agreed number
of shares at an agreed price at (or
before in the case of American style
†
options ) an agreed time in the
future. Combined with margin
lending, an investor can manage
against any negative movement in
share price and protect their
portfolio. The following case study
explains how.
†
There are two different exercise styles:
American style, which means the option can
be exercised at any time prior to the expiry;
and European style, which means the option
can only be exercised on the expiry day.
CASE STUDY
STRATEGY BENEFITS FOR THE INVESTOR
Consider an investor who uses a
margin loan to purchase 1,000
shares in Company A at a share
price of $30.00 totaling $30,000.
Although the investor is quite
bullish on the company, the market
as a whole has had a strong run in
the past six months and numerous
global economic and political factors
could cause investors some nervous
jitters and place downward pressure
on the market in the coming six
months. The investor speaks to her
financial adviser about the market
outlook.
The financial adviser,
noting her client’s concerns,
suggests adding some protection to
the shareholding, in anticipation of a
drop in the market.
• A guaranteed sale price of $30
while the protection is in
place
• The profit is unlimited above
the share price of $31*
• Margin calls caused by a
possible fall in share price are
mitigated
• Continue to receive entitlements
such as dividends and voting
rights
• Opportunity to reassess the
investment in six months time
After discussing the idea further, the
investor purchases 1 contract of a
$30 Put option on Company A for
$1,000 which expires in six months
time. The Put option gives the
investor the right but not the
obligation to sell their shares at $30
over the next six months, including
on the day the option contract
expires.
The diagram below illustrates the
profit outcome at varying share
prices with and without protection.
As illustrated, the Put option allows
the investor to lock in a price which
shields the investment from any fall
in value below the protected level,
while also receiving the benefit of
any increase in share price.
*Calculated by the initial purchase price of $30
per share plus the purchase price of $1 per
option unit.
Please note, Put options could also
be used in conjunction with the
previously mentioned diversification
strategy, as the investors borrowing
capacity is often increased. When
Put options are held over the
underlying shares, the lender is
often prepared to allow the investor
to borrow a higher amount against
those shares, due to the protection
in place.
STRATEGY RISKS FOR THE INVESTOR
Purchasing Put options on a margin
lending account can potentially
increase the borrowing capacity in
the portfolio. If the amount
borrowed increases, an investor
should be aware that the Put option
has a limited life and further equity
may be required when the option
expires.
$10,000
$8,000
$6,000
$4,000
Profit
STRATEGY BENEFITS FOR THE INVESTOR
$2,000
$-$2,000
-$4,000
Profit with Protection
-$6,000
Profit without Protection
-$8,000
-$10,000
$20
$22
$24
$26
$28
$30
$32
$34
$36
$38
$40
Company A Share Price
Assumption: the portfolio only holds a single security and excludes brokerage, margin lending and
other fees and charges.
©2013 Morgan Stanley Wealth Management Australia Pty Ltd
2
For further information concerning
risks associated with trading
Exchange Trades Option, refer to the
ASX booklet “Understanding Options
Trading” located on the ASX website.
www.asx.com.au/documents/resources/U
nderstandingOptions.pdf
Who could use these
strategies?
The strategies presented will suit
investors who have a general bullish
view on a particular security or
investment portfolio; however, there
are some concerns about the
potential risk of a market downfall
and would like to adopt some
protective measures.
Risks of Margin Lending
Like any investment, there are
various risks involved. With margin
lending, it is important that an
investor not only understand these
risks, but also understand how they
can be managed.
VOLATILITY,
MARGIN
CALLS
A N D M A G N I F I E D L O S S E S : While
Margin Lending can increase your
potential returns, your potential losses
can also be increased.
A market downturn can lead to
margin calls triggered on the loan,
which would require an investor to
deposit funds, sell securities or lodge
other forms of acceptable securities.
Market downturns may also lead to a
situation where there is negative
equity, that is, the value of the
investments is lower than the
amount of debt owed.
I N T E R E S T R A T E R I S K : A rise in
interest rates will increase the
investors cost of borrowing and may
lead to a change in gearing profile. It
is important for an investor to
consider how interest rate increases
would affect their ability to service
their debt.
REDUCED INVESTMENT INCOME:
When economic conditions are
challenging, some companies may be
forced to reduce their dividends as a
capital conservation measure. This
would impact investors who rely on
company distributions to offset the
cost of borrowings. Therefore, it is
important for investors to have
independent sources of income they
can use if the investment income is
lower than expected.
Investors can manage and reduce
risks associated with margin lending
in a number of ways:
• Don’t borrow the maximum
available
• Maintain a diversified portfolio
of quality investments
• Pay interest regularly
• Credit dividends into your
margin loan
• Monitor the portfolio and be
proactive
Next steps
If you would like to know more
about protecting your investments,
please contact your financial adviser
or contact Morgan Stanley Margin
Lending on 1800 062 794.
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tax professional.
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