Investment Road Test: Macquarie's GEI v CBA's PEL

There's one key point of difference between two of the most popular gearing products on the market.

PORTFOLIO POINT: Macquarie's and CBA's gearing packages both offer good levels of protection for investors. The main difference between the two relates to cost.

Each year as tax season approaches, many investors start to think about sprucing up their portfolio by borrowing to buy their favourite investments. Doing so in a tax-effective format is one of the factors that induces this activity; overall the prospect of building wealth is the primary driver for most geared investors. Of course, since the GFC, the capacity and appetite for gearing has been smashed for many investors; lack of investment funds and/or weakened personal balance sheets, combined with wariness about costs and potential for poor returns are the main impediments for most. In this week’s Investment Roadtest we compare, the differences between two of the most popular sharemarket gearing facilities, the Macquarie 'Geared Equity Investment Plus' and CBA’s 'Protected Equity Loan'. We’ll come back at a later date to look at the use of these types of protected loans inside SMSFs – another growing consumer of these products.

The GEI and PEL use the same broad concept to provide an interest-only loan, with an LVR (loan to value ratio) of 100%. I was part of the team that created the first GEI in 1990 for a syndicate of Melbourne accountants who wanted to borrow to invest in NAB shares. Looking back, it’s easy to see the motivation of the investors – NAB shares then were trading at $3.50 per share – but at the time the first loan was created, it was hard to overlook the fact that NAB shares were at the top of their trading range and questions were being asked about their relative cost and value.

The protected loan was born as a way of providing investors with 100% LVR facilities, and at the same time creating protection against share prices falling. This feature benefits both parties, because it allows the lender to secure the risk involved with such a high LVR, as well as providing the investor with the ability to set up a geared share portfolio without the need to contribute any capital, as well as paving the way for an “interest only” loan facility. Given the shambles involved with high levels of gearing using alternatives such as margin loans (e.g. Storm Financial), the protected loan structure can also be seen as having a powerful social good.

That’s because the structure of the protected loan includes payment through the interest rate for the cost of a “put option” over the underlying shares. The put option is like an insurance contract for the benefit of both the lender and borrower. It’s held by the bank as part of the hedging created to support the protected loan, and benefits the investor because it means they have no capital risk if the value of the stock at maturity is lower than the original price paid at the inception of the loan.

These protected loans are the lowest cost way for investors to borrow to enter the sharemarket, and by explicitly dealing with solvency risk, they open the prospect of successful gearing to a wide range of investors. Because the investor doesn’t have to place any capital up front into the facility – unlike margin loans where around 30% of the purchase price of a share is required as an upfront capital contribution – the protected loan can be started using a prepayment of the first year’s interest, or can be paid off monthly in arrears (interest only). Using home equity avoids the need to make a capital contribution for a new loan, but does place the investor’s home equity at risk in the event of falling share prices.

The catch is that the interest rate for the protected loan is higher than the cost of a margin loan or home equity finance. That’s because the higher interest rate includes the cost of buying the protection for the loan facility. Some protected loans will explicitly identify the cost of the embedded put option with the loan structure; others will imply it by telling you what margin above a basic loan interest rate they are charging for the protected loan. CBA states that its basic interest rate for the protected loan is 8.3% pa, with the protection cost being added as a separate component, differing depending on the stocks and risk selected.

It’s in the treatment of the interest cost that Macquarie and CBA most significantly differ. If you re-read the statement above (that protected loans are the cheapest form of share gearing), you should understand that the absence of any need for an upfront capital contribution is replaced by the higher annual interest cost for the protected loan. Total interest rates in the mid- to high-teens are usual for these loans. So obviously, any mechanism that can be used to reduce these annual interest costs should be welcomed.

The Macquarie facility allows borrowers to spread their investment across a range of ASX-listed shares and managed funds, and also to use the loan to invest into the MBL cash management account. The loan funds used for the cash account don’t incur a protection charge and when amortised across the entire loan facility, this reduces the headline interest rate charged. I compared $100,000 invested into the MBL and CBA protected facilities, but for MBL we added an additional $100,000 invested into their CMT. Using the same basket of blue chip shares, I found that Macquarie quoted a total interest rate of 8.91% across the total portfolio, with CBA quoting a rate of 12.60%.

The investment trade-off is that the returns from the cash management account are capped at the interest rate earned on the deposit, and this effectively drags the overall rate of return during the life of the loan. I analysed the difference for the two loan facilities in the table below. These numbers are for a five-year loan term with annual interest payments and an assumed 7% pa growth rate.

-Comparison of Macquarie's GEI and CBA's PEL
Macquarie
CBA
Portfolio size
200000
100000
Allocation to cash
100000
0
Interest rate
0.0891
0.126
Non deductible protection cost
-6070
-21485
After tax cost
-20053
-21868
Tax rate
0.465
0.465
Capital growth
0.07
0.07
Portfolio value at maturity
240167
140167
Portfolio value at start
200000
99937
Net gain (value at maturity less portfolio value at start)
40167
40230
Non deductible protection cost
-6070
-21485
Taxable gain/ loss
34097
18745
Tax payable
-7928
-4358
Net after tax gain on portfolio
32239
35872
After tax cost of investment
-20053
-21868
Net gain/loss after tax over term
12186
14004
Net after tax
1817

When the before and after-tax costs of protected loans are analysed, it can be seen that they are around the same costs as buying a call option over the underlying shares. Like call options, the cost of the protected loan is a wasting asset – once spent, it is lost – and so can only rationally be appraised if the investor has the view that the potential for return over the term of the protected loan (from dividends and capital growth) is likely to exceed the outlay. For wary investors, who are overweight cash (i.e. they hold more cash than a traditional asset allocation model would indicate), the protected loan can be a good way to obtain some exposure to sharemarket growth at the same time as maintaining the cash exposure. For others – especially those lacking financial resources and needing to grow wealth for retirement – the protected loan may be a good way to do so with limited resources. Loan terms of one, two, three or five years can be selected, but beware that both the CBA and Macquarie facility don’t offer great flexibility if loans are repaid early or shares are sold prior to maturity.

The Macquarie GEI Plus has the additional benefit of an ATO product ruling (PR 2011/5) and because both facilities involve real borrowings used to buy real shares, they should provide the ultimate in tax simplicity and robustness. The ATO limits the amount of interest that can be claimed upfront for investors, to a margin of 1% above the RBA secured home loan borrowing rate – currently a total of 7.91% – so the current capped deduction rate is 8.91%. The excess is added to the CGT cost base of the share and hence helps to reduce CGT payable if the share is sold at a profit.

Both facilities offer high levels of protection and use relatively simple technology to provide investors with the ability to borrow 100% of the cost of shares. Depending on how important it is to lower the annual cost, investors can choose to work with the lower headline interest rate charged by Macquarie, or to benefit from the stronger overall returns available from the CBA facility.

The score: Macquarie GEI Plus – 4.0 stars
1.0 Ease of understanding/transparency
0.5 Fees
1.0 Performance/durability/volatility/relevance of underlying asset
1.0 Regulatory profile/risks
0.5 Innovation

The score: CBA Protected Equity Loan – 4.0 stars
1.0 Ease of understanding/transparency
0.5 Fees
1.0 Performance/durability/volatility/relevance of underlying asset
1.0 Regulatory profile/risks
0.5 Innovation


Tony Rumble is the founder of the ASX-listed products course LPAC Online. He provides asset consulting and financial product services with Alpha Invest but does not receive any benefit in relation to the product reviewed.

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