Odds stacked against margin lending

PORTFOLIO POINT: In the past 28 years, investors would have had just a 23% chance of making reasonable returns by marginal lending.
The scandal that is margin lending for shares is starkly exposed when we take the advice given by Watergate’s 'Deep Throat’, to “'¦ follow the money to find the guilty parties”.

In the margin lending business, following the money reveals a steady diet of concealments, biases and downright lies fed to both planners and investors. This probably explains why so many feel misled and bitter about margin lending because, for the most part, margin loan product providers pay for – and own – the information that investors rely on to make decisions. It is akin to a sheep accepting the wolf’s assurances she will be safe in his company.

We know this from experience because we have danced with the devil that is margin lending and yes, we cashed his cheques. But the dance finished early (as did the cheques!) because, as tellers of truths, we quickly began to tread on our client’s toes.

The challenge for planners is to disclose the risks in a service or product in a manner that investors can understand, which allows the investor to give a properly informed commitment. The planning process must enable the planner to share the decision-making with the client.

Our dance with the devil

It was a couple of years ago when the bulls ruled the day. Our client sold margin loans and our brief was simple: develop a series of compelling case studies illustrating how different types of investors could “profit” from margin lending. They were the typical client profiles seen every day by financial planners:

• Single, young, high-income professionals.
• Newly married couple, both working.
• Married couple with teenage children, one parent not working.
• Empty nesters, both working.
• Divorced Family Court victim.
• Newly retired couple.
• Retirees living on investment returns.

So we modelled portfolios heavily featuring margin loans. Instantly, we knew we were in trouble: the story just didn’t stack up in the way we knew our client “expected” it to. In fact, when we took into account the risks, costs and rewards there were only two groups of investors to whom we could, in good conscience, consider recommending margin lending strategies:

• Single, young, high-income professionals, because they have the time and resources to rebuild if the margin loan blows up.
• Divorced Family Court victims, because they have diminished assets and limited time they need to take gambler-style risks in hope of a big payoff.

We presented these results to our client. They were not happy. Our names were instantly deleted from their dance card.

But we kept our data on those portfolios. We recently revisited it in light of the 2008 equity market collapse. The black swan that landed in 2008 was bigger and uglier than anything since 1929! After the events of 2008, our updated research placed margin lending in an even more difficult light.

Gambling is not investing

Our numbers show that over the past 28 years investors have only had a 23% chance of making reasonable money from margin lending. That is not investing; that is gambling.

What do we mean by reasonable? To compensate for the risks being taken, we believe that a margin lending program should return a minimum of 5% after tax. That is $5000 each year for every $100,000 borrowed and at risk in the market. However, over the past 28 years, only 23% of rolling five year periods produced that outcome; the rest fail to achieve this benchmark.

You’ve all seen the marketing literature showing how margin lending can produce wealth because margin lenders will keep paying for that type of “work”. They won’t, however, pay for or publish work that says “less than one in four shot of success”.

Investors suffer when the full story is not told:

• They take on risks that they do not understand and are not suited to. In fact, we doubt that many ever had their risk tolerance properly assessed before being saddled with their margined portfolio.
• They receive margin calls, they lose some or all of their portfolio, and in the worst cases they have to sell their homes; their lives and future plans devastated.
• Some, gutted by their mistakes, will fight with spouses, suffer depression, divorce or even in the most devastating of consequences take their own lives.

The human misery and tragedy arising from margin lending is very, very real and it is not covered in either the margin lender’s glossy brochure, or the simplistic illustrations that are often the only “education” the investor and planner is given.

Our data

We took just over 28 years of data, covering both bull and bear markets. Let’s summarise the inputs:

• As the results are based on the Accumulation index, dividends are included.
• Cost of borrowing is 5% per annum (payable monthly) over the bank bill rate.
• We have assumed no annual costs of investment in the Accumulation Index.
• We have assumed no brokerage costs when purchasing or selling shares.
• We used the data for the S&P ASX 200 Accumulation index (All Ordinaries index prior to 1992) and the UBS WDR Australian Bank Bill Index from December 31, 1980, to January 31, 2009.

From this data we derived the monthly returns from the stockmarket and the base rate for the cost of funds for a margin loan. (Margin loans are usually charged at a cost of about 5% over the bank bill rate). We looked to rolling five-year annualised returns to give us a reasonable view of the outcomes:

Our initial conclusions were that you would have needed to be a good market timer (and probably a better than average fund manager and fund selector) to make money out of margin lending. The average results were:

nBy the numbers
	Monthly (%pm)	Yearly (%pa)
ASX 200 Accumulation index	0.96	12.14
Cash index	0.75	9.38
Margin loan cost (monthly)	0.42	5.12
Profit from margin lending	-0.21	-2.36

Let’s have a look at the returns on a month by month basis:

The results:

• Out of 337 months of data, positive returns occurred in 177 months, or 53% of the time.
• Out of 337 months of data, negative returns occurred in 160 months, or 47% of the time.
• The average monthly return over 337 months was negative 0.21% per month, or negative 2.36% per annum.
• The worst month would have been October 1987, where the investment would have lost 43%.

After-tax returns were not much better. We modelled for a top marginal tax rate payer:

The average after-tax results were:

nHow they performed
	Monthly (%pm)	Yearly (%pa)
ASX 200 Accumulation index	0.7	8.76
Cash index	0.4	4.92
Margin loan cost (monthly)	0.22	2.71
Profit from margin lending	0.08	1.13

We have assumed that:

• 70% of dividends are franked.
• Dividend rate is 5% pa.
• Corporate tax rate is 30%.
• Individual marginal tax rate is 46.5% for income and 24% for capital gains.
• No deferral of taxation liabilities for tax.

The results:

• Out of 337 months of data, positive returns occurred in 185 months, or 55% of the time.
• Out of 337 months of data, negative returns occurred in 152 months, or 45% of the time.
• The average monthly return over 337 months was positive 0.08% per month, or positive 1.13% per annum.

Our conclusions

We think it is reasonable to expect rolling five-year returns of at least 5% after tax to compensate for the risks of using a margin loan to purchase shares, but our data shows this outcome is not even close to being achieved on a regular basis in one of the best bull market runs in history.

Margin lending looks to be a gambler’s strategy. As a less than one in four shot of success, it cannot be considered an investment strategy.

We would argue that the vast majority of investors are not natural margin lending clients. Our understanding of financial risk tolerance suggests that the majority of investors would be naturally more comfortable with a more balanced portfolio.

At the very least, before taking on a margin loan investors must have the risks properly explained to them so that they can actively and consciously decide to take on those risks. Going forward this would be a minimum obligation for both direct and advised margin lending clients.

It’s time for the education of the benefits and risks of margin lending to be independently delivered

Paul Resnik and Peter Worcester are consultants with more than 70 years of practical financial services industry experience.