Topic 6 Leveraged InvestmentsBAFI 1016 Personal Wealth Management

IntroductionLeveraged investing is the buying of investment assets for the purpose of generating a return using borrowed funds. Advantages are in the areas of taxation and capital gains.Investors must have a strategy in place to manage the associated risks.There are two main methods of leveraging: borrowing and using the futures and options market.

Leveraged InvestingLeveraged investing is not new but has been used for many years in the form of mortgages, futures and options.Today it is increasingly being used for wealth creation.Leveraged investing generates greater returns than from savings alone.

GearingBenefits of GearingIncrease in value of leveraged asset.Service debt from existing income.Risks of GearingServicing (repayment of interest and capital) of borrowed funds.Decline in asset value.Gearing describes the use of borrowed money to buy investment assets and achieve a return greater than the cost of using the borrowed funds.

Income Taxes and Geared InvestmentsDividend, interest or rental income is assessable for tax purposesInterest expense on a loan for the purpose of investing in income producing assets will be a deductible expenseThis will be the case whether the investment is positively or negatively geared

Positive GearingPositive gearing is the use of borrowed funds to purchase an income producing asset where the income is greater than the interest expense and other associated costs.Not considered tax effective.Good retirement income strategy.Risk-minimisation strategy for investors particularly if seeking long-term capital gains.

Negative GearingNegative gearing occurs where an investor buys an income producing asset using borrowed funds, andthe costs of owning the asset are higher than the income from the asset.Popular because the ATO allows losses to be claimed against personal income.Most common types are investment in rental properties, a share portfolio or managed funds.

Negative Gearing example:Kevin has assessable income of $20,800 and allowable deductions of $21,600 from an investment thus leaving an $800 lossIf we assume he is on the 30% marginal tax rate the he will have a tax shield of $240 to reduce his assessable income and reduce tax payable

Risks of Negative GearingAnticipated annual income is lower than expectedAnticipated expenses are higher than expectedIf a lender changes the terms of a loan this may affect the benefits of negative gearingA reduction to the investors other income could lower their marginal personal tax rate making the tax shield less attractiveThe investor is forced to sell at the wrong time in the market cycleAsset specific factors eg bad tenantsThe asset does not generate the capital gains anticipated

Gearing RatioGearing ratio is used to measure amount of debt in relation to current market value of asset purchased with debt.whereInvestors contribution = market value of asset borrowed funds

Capital Gains Tax (CGT)Date of commencement of the CGT was 19 September 1985Assets acquired after 19 September 1985 and 21 September 1999 generally allow the taxpayer to select either the indexation method or the discount methodAssets acquired from 21 September 1999 generally require the taxpayer to select the discount method to apply to any capital gainThe limiting factor to the selection of the indexation method or the discount method is the requirement that the relevant asset is held for at least 12 months - where this does not apply, the taxable capital gain will be calculated without any application of either the indexation method or the discount method

CGTCapital losses may only be claimed capital gains if no capital gain in a year that a capital loss is incurred, the loss may be carried forwardAn advantage of shares is that only a part of a share portfolio may need to be sold thusd limiting capital gains whereas real estate is a lumpy investment

Mortgages 3 normal different types of mortgages:Level payment fixed-rate mortgageGraduated payment mortgageAdjustable-rate mortgage

Variations allowed with deregulation:Interest-only loansBullet payment loansDevelopment loansEquity release loansHome Equity conversion loansSecond-mortgage loans

Reverse Mortgagesa loan, secured by real estate, where the interest is not repaid but accrues until such time as the real estate is sold and the accrued interest and principal are repaid

Margin LendingMargin lending occurs when a lender advances funds and the amount borrowed is secured by investment assets.Borrower must maintain a debt-to-value ratio of the assets used as security.This value is set at the beginning of the loan and will change as market value of the portfolio changes.

Margin Lending continuedBENEFITSGreater access to wealth-creating assetsDiversificationLiquidityPersonal income tax benefitsDirect investing and managementRISKSCapital lossesFunding interest paymentsFunding margin callsFluctuating value of the portfolio

DerivativesContracts for differenceFuturesOptionswarrants

Contracts for Differencean agreement between a buyer and a seller to exchange the difference in value of an underlying assetThe buyer is going long and expects the price of the underlying asset to riseThe seller is going short and expects the price of the underlying asset to fallASX or OTC CFDsCan also be used to hedge a physical position

Futures Contracts A futures contract is an agreement to trade something in the future:Either to buy or sell.A specific amount of a specific asset.Deposits are exchanged at beginning of contract to ensure parties will honour their obligations.Future price needs to be greater than current price.

Futures Contracts Popular in global financial markets because an established futures contract makes it easy for traders and investors to buy and sell the contract.This ability to find buyers and sellers easily is known as liquidity.Traded on registered futures exchanges.Investors make profits when they buy futures at a lower price than they sell it.

Futures Contracts Example

Date Trade Investment4 Jan Buy 1 gold contract with a speculation of 1000oz. Settlement date: 15 March Purchase price: $520 per ounce Value of contract: $520 000 Deposit: 10% of market value $52 00010 MarGold price increases to $536 per ounce Value of contract: $536 000 Sell futures contract at $536 & lock in profit of: $536 000 $520 000 = $16 000 + $16 000Deposit returned + $52 000

Futures Contracts Realised returnCapital used:At beginning$52 000Add profit$16 000At end$68 000 r = $68 000 $52 000 x 100 $52 000 = 30.77%

Futures Contracts Other issues to consider in relation to futures contracts areMargins and depositsThe futures exchangesThe clearing house of futures exchangesNovation

Futures Contracts BENEFITSLiquidityCredit securityFlexibilityRISKSFunding of margin callsMarket volatilityNo income streamKnowledge risk

OptionsAn option is a security that gives the holder the right but not the obligation to buy or sell something in the future at a fixed priceBuyer of option has no obligation to buy/sell if market price is below the option priceSeller has an obligation to complete the transactionTwo types of optionsPut optionsCall options

OptionsRights of option buyers and sellers

Type of OptionBuyers RightsSellers ObligationsCall optionsChoice of buying underlying security or assetMust sell underlying security or asset if option exercisedPut optionsChoice of selling underlying security or assetMust buy underlying security or asset if option exercised

Options Brokers work out the amount to charge for the premium of an option on a financial asset based on, examples: risk, liquidity, time to maturity, volatilityOptions markets are traded worldwide in one of two ways: On a registered exchange such as the ASX or,Directly between two parties in an over-the-counter (OTC) transaction

Other Complex Leveraged Investments - WarrantsWarrants are leveraged investments in the shares of a company.Traded on the ASXIssued in a seriesEndowment and instalment warrants are not issued by the company in which the shares are being bought, but by a third party institution

WarrantsThe holder of a warrant has the right to buy or sell the underlying asset so an investor would seek to be long if they expect prices to rise or short if they expect prices to fallWarrants can be broadly categorised as:Trading style (higher risk / return attributes) orInvestment style (lower risk / return attributes) and includes endowment and instalment warrants which are effectively a long term loan to buy shares

Other Complex Leveraged Investments -Contracts for DifferenceContracts for Difference are highly geared derivative contracts.Carry significant risk.5% of value of shares acquired as deposit. Remainder is borrowed.

Overlapping Suitability of Derivative Productsan investor could find themselves in a position whereby they could pursue the same investment opportunity via a number of different derivative products

SummaryLeveraged investing is an effective use of small amounts of investing capital.Leveraging is increasingly common in a personal investment portfolio.Leveraging is reliant on expected returns, ability to service debt and tax advantages.Leveraged investments comes with a number of investment risks.