T he scandal that is margin lending for shares is starkly exposed when we take the advice given by Watergate’s ‘Deepthroat’ 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 that he will be safe in its 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 clients’ toes.
The challenge for planners is to disclose the risks in a service or product in a manner that investors can understand, which allows them to give their properly informed commitment. The planning process must enable the planner to share the decision making with the client.
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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 professional;
- newly married couples, both working;
- married couples with teenage children, one parent not working;
- empty nesters, both working;
- divorced Family Court victims;
- recently retired couples; and retirees l
- iving on investment returns.
Gambling is not investing
Our numbers show that over the last 28 years investors have only had a 23 per cent 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 per cent per annum after tax. That is $5,000 each year for every $100,000 borrowed and at risk in the market. However, over the last 28 years, only 23 per cent of rolling five-year periods produced that outcome — the rest failed to achieve this benchmark.
You’ve 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 concedes a ‘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 are devastated; and some, gutted by their mistakes, will fight with spouses, suffer depression, divorce or, 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 which 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 cent 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 share market and the base rate for the cost of funds for a margin loan. (Margin loans are usually charged at a cost of around 5 per cent over the bank bill rate.) We looked to rolling five-year annualised returns to give us a reasonable view of the outcomes (see graph 1).
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 are outlined in table 1.
Graph 2 outlines the returns on a month-by-month basis.
The results:
- out of 337 months of data, positive returns occurred in 177 months or 53 per cent of the time;
- out of 337 months of data, negative returns occurred in 160 months or 47 per cent of the time;
- the average monthly return over 337 months was negative 0.21 per cent per month, or negative 2.36 per cent per annum; and
- the worst month would have been October 1987, where the investment would have lost 43 per cent. After-tax returns were not much better. We modelled for a top marginal tax rate payer (see table 2 and graphs 3 and 4).
We assumed that:
- 70 per cent of dividends are franked;
- dividend rate is 5 per cent per annum;
- corporate tax rate is 30 per cent;
- individual marginal tax rate is 46.5 per cent for income and 24 per cent for capital gains; and
- no deferral of taxation liabilities for tax.
The results:
- out of 337 months of data, positive returns occurred in 185 months or 55 per cent of the time; and
- out of 337 months of data, negative returns occurred in 152 months or 45 per cent of the time. The average monthly return over 337 months was positive 0.08 per cent per month, or positive 1.13 per cent per annum.
Our conclusions
We think it is reasonable to expect rolling five-year returns of at least 5 per cent 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. With 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 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 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 on 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 combined. They both have firm views.
The Black Swan refers to a book published in 2007 by Nassim Nicholas dealing with extreme events in financial markets. Resnik and Worcester have taken this a step further, suggesting that if financial planners do not anticipate such events they risk failing their clients.
