CityIndex CFD Portfolio

I decided to create a portfolio of CFDs for the ASX20 stocks (top 20 Australian listed companies by market capitalisation), exlcuding the financials. This provided a list of ten stocks and I bought enough units of each stock CFD to give them equal weight in this portfolio. Overall the contracts have a value of approx. $3,000 worth of shares, and the required margin is around 10%. This used up approximately $300 out of the $400 account balance I had before making these trades. Combined with the $100 'credit' allowed on this account it means that these stocks could drop by around 8% before my account would be liquidated (and I'd end up owing CityIndex $100). On the upside, if the market recovers from here, a 10% gain would boost the value of these stocks by around $300, giving me a ROI of around 100%. It illustrates the extremely geared nature of using CFDs for "investing" - hence the reason they are mostly used for speculative day trading.

It will be interesting to see how the interest charges work out in practice. In theory interest is charged on the entire value of the CFD contract (not just the margin value), and the rate is a few percentage points above the RBA overnight cash rate. However, in practice interest charges are debited daily, and on the small amounts due each day on $3,000 worth of CFD contracts rounding to the nearest whole cent could have a significant effect. After one month I'll add up all the interest amounts and work out the effective interest rate being charged. I'm hoping to just hold on to these positions for a long period (rather than actively trading), so the interest charge will be important.

After the latest trades my CityIndex CFD portfolio is as follows:

Currency AUD
Cash Balance 411.56
Open Equity -14.72
Net Equity 396.84
Credit Allocation 100.00
Margin Requirement 286.89
Trading Resources 209.95
Account Summary
AUD 484.49
USD -85.05

CFD Trades
17 Jul 2008 BHP Billiton (AUD) CFD___ Buy Market _8 @ $38.03 $304.24
17 Jul 2008 Brambles Industries CFD__ Buy Market 44 @ _$7.90 $347.60
17 Jul 2008 CSL CFD__________________ Buy Market 10 @ $34.94 $349.40
17 Jul 2008 Foster's Group CFD_______ Buy Market 75 @ _$4.61 $345.75
17 Jul 2008 Rio Tinto (AUD) CFD______ Buy Market _3 @$117.16 $351.48
17 Jul 2008 Telstra Corp CFD_________ Buy Market 80 @ _$4.30 $344.00
17 Jul 2008 Woodside Petroleum CFD___ Buy Market _5 @ $59.24 $296.20
17 Jul 2008 Woolworths (AUD) CFD_____ Buy Market 14 @ $25.50 $357.00
17 Jul 2008 Wesfarmers CFD___________ Buy Market 10 @ $32.53 $325.30

Although the US and UK markets were up on Thursday night, the Australian market dropped on Friday - mainly due to the resource stocks which are a significant part of this portfolio. Therefore the portfolio had lost $14.72 the first day. If the Australia market doesn't bottom out soon this could be a very short-lived experiment.

Subscribe to Enough Wealth. Copyright 2006-2008

Margin lending dilemma

The end of the financial year is nigh, so it's once again time to decide whether or not to pre-pay the next twelve months interest. The main benefit of doing so is that if it's paid before 30 June the entire amount is deductible in this year's tax return. The other potential benefit of pre-paying the interest is that the interest rate is fixed, rather than being variable if you are paying monthly. There appears to be little chance of an interest rate cut in the next twelve months, but some possibility that the interest rate might increase another 0.25% or 0.50%.

Each of my three margin lenders is offering different interest rates for prepaying twelve months interest. St George margin lending is offering 10.25%, but because we have our home and residential investment property loans with them we are "gold" clients, so I get a 0.25% discount on the interest rate, bringing it down to 10.00%. Yesterday I faxed in the paperwork to fix and prepay the interest on $70,000, which is almost the entire loan balance on this account.

I'll probably also fix and prepay most of the loan balance on my leveraged equities account, but I'll leave about $8,000 at the variable rate so I can reduce the loan balance at any time if I sell off some odd stock lots that were left sitting in this account after some takeover activity. Leveraged Equities usually mails me a prepayment form in early June, so I don't yet know what interest rate is on offer. Hopefully it will also be 10% or less.

My third Australian stock account on margin is with Commonwealth Securities (ComSec). They sent out a prepayment offer last week, but the interest rate on offer is an exorbitant 10.35%! This account has my largest margin loan balance (just over $150,000), so I'll have to phone them and try to negotiate a better rate. If they won't come to the party I'll consider transferring the holdings to my St George margin loan account. I'd rather not have to do so, as it might trigger a capital gains tax liability. It might also be a hassle arranging for the Comsec loan to be paid out if the shares on that account are transferred to my St George margin account.

The higher interest rate charged by ComSec seems even more excessive considering that they don't pay any trailing fees to brokers (as I found out from YourShare when I arranged to get a 50% rebate of trails on my various investment and loan accounts by making them my nominated broker). If I borrow funds from St George rather than ComSec I would get a rebate of trailing fees worth around 0.15% in addition to the interest rate being 10.00% rather than 10.35%

The interest rates on my margin loans have increased from around 8% a year ago, to around 10% today. There's considerable risk that the overall ROI of my stock investments won't exceed 10%pa in the medium term, which would make the use of gearing an ineffective investment strategy. However, most of my Australian stock holdings include considerable unrealised capital gains, so I'm not keen on selling stocks in order to reduce my margin loan balances at this time.

If interest rates drop and margin lending remains a useful investment strategy, I'm hoping to be able to liquidate these holdings gradually during my retirement. Under the current superannuation rules my SMSF pension income won't be taxable and doesn't even have to be included on tax returns. This would (I think) mean that it wouldn't be counted as income when working out the marginal tax rate to be applied to any capital gains realised during retirement. On the other hand, the Rudd government has indicated that they want to include such retirement pension income in some social security calculations, so presumably the data would then be available to the ATO and might end up also affecting capital gains tax calculations.

It's a bit hard trying to make sensible decisions about taxation planning when the rules can change at any time. In fact, some Labor politicians have expressed a desire to do away with the current 50% CGT concession for "long term" capital gains, so holding on to my stocks could end up costing me a lot extra tax in the long run. Perhaps I should hedge my bets by selling off a portion of my Australian stock portfolio and use the proceeds to reduce my margin loan balances. Of course, if I want to do that during the next financial year I can't fix and prepay the entire loan balance. Decisions, decisions...

Subscribe to Enough Wealth. Copyright 2006-2008

An attempt at benchmarking my portfolio performance

My investment portfolio is a bit like an old attic full of family "treasures" that have been accumulated over the years. And it often seems like I've managed to accumulate some wealth in spite of, rather than because of, my investment choices. Many of the investments purchased seemed like a good idea at the time, but don't form a sensible part of any overall asset allocation strategy. And, just as I always seem to pick the slowest queue in the supermarket*, I seem to have a knack for going ahead with some poor investments while deciding against the ones that eventually became "10-baggers".

So it would be nice be able to compare my actual investment performance with what I "should" have achieved, given my chosen asset allocation and level of gearing. Benchmarking my portfolio isn't a simple matter as my asset allocation is slowly changing over time (by buying an investment property and then our own home, I've started out with a lot more real estate in my investment portfolio than I'd really like. Over time this should slowly drop from 50%+, towards my target allocation of around 25%). It's also complicated by variations in the level of gearing that I have - the property mortgages are slowly declining, while the stock portfolio gearing tends to fluctuate around my desired gearing level (60% LVR) as I buy and sell particular investments:


A final complication is the irregular addition of savings to my investment portfolio. I aim to add around $30K pa in 'savings', but this comes from a variable mix of superannuation contributions, mortgage principal repayments, funding the negative cashflow of my leveraged stock portfolio, and some ad hoc new investments (such as paying for the T3 share installments).

To simplify things I assumed a constant $30K addition to my investments at the end of each year, and a constant overall gearing level of 100% (50% LVR). I've also assumed that the average cost of my investments loans is around 2% above the cash rate. A recent investment report from Count Financial Planning provides the required data for a rough benchmarking of my portfolio over the past 1-, 3- and 5-years:

Simplified^ Benchmark:
50% - Property (Australian House Prices, Sydney median annual values from REIA)
50% - All Ordinaries Accumulation Index.

Data (Quarterly figures up to 31 Apr 08):

1-year 3-year 5-year
% pa % pa % pa
--------- ---------- ----------
50% Property - Syd 2.70% -0.99% 3.21%
50% All Ords Accum. -4.56% 17.39% 18.40%

Overall, ungeared -0.93% 8.20% 10.81%

CPI 4.24% 3.22% 2.80%

Cash rate 7.10% 6.39% 5.99%

Approx Loan int rate 9.10% 8.39% 7.99%

Benchmark" -10.96% 8.01% 13.63%

My Portfolio -5.26% 8.06% 11.46%

" = ungeared rate + (ungeared rate - int cost of gearing).

The figures show that:
: gearing improved returns over 5 years, but has the reduced 3 year average return (due to the negative investment returns of the past 12-months).
: My portfolio did better than this rough benchmark over the past year, but didn't perform as well as I'd expect over 5 years. Probably because I had some international stock exposure in my retirement account which isn't reflected in this rough benchmark.
: Sydney real estate was not the best place to be invested over the past 5 years!

Since I'm not a fund manager, benchmarking my portfolio is really just for idle curiosity. If I ever get all my investment information up to date in Quicken I may have a go at doing this more accurately.


* There's actually a valid reason why you always seem to pick the wrong queue. If there are ten queues, you only have a 10% chance of picking the fastest line. So, 90% of the time you'll end up sitting in a 'slow' queue watching one of the others queues proceed much faster. It's just human nature to pay attention to queue(s) that are faster than yours, while ignoring all the other queues that are even slower than the one you're in! ;)

^ My current allocation includes a mix of Australian and International stocks, so the benchmark should probably be:
50% Sydney Residential Property
25% Australian All Ords Accumulation Index
25% MSCI world (ex-Australia) Accumulation Index.

My Target Allocation is something like:
10% - Cash/Bonds/Alternative (Hedge/Agri/Art/Gold etc).
25% - Property (Mix of direct investments and Listed Property Index)
35% - Aust Shares (Index)
30% - International Shares (Index)
but I don't expect to get to this mix for another decade or so, buy making additional investments only in those asset classes which are currently underweight.

Subscribe to Enough Wealth. Copyright 2006-2008

Increased my investment in the Colonial FirstState Geared Share Fund using margin

My Margin Loans with Leveraged Equities and Comsec are almost fully utilised (>80% MU, with margin calls if MU exceeds 105%), but I have a fairly low gearing level with my StGeorge Margin Loan, as I transferred all my miscellaneous mutual fund investments into this account several years ago and have only been using a 50% geared savings plan of $200/mo to slowly add to my investment in the Colonial FirstState Geared share plan. That particular investment has done well during the bull market, but is currently down around 50% from it's high last October. Assuming we're close to the bottom of the Australian bear market (which seems possible, given our economy is still growing around 4%pa and exports due to the commodity boom expected to rise another 30% in the next 12 months) it may be a good time to invest more into this internally geared fund.

The fund invests using internal gearing and generally invests in high quality companies in the S&P/ASX 100 Accumulation Index. These companies generally have strong balance sheets and their earnings are expected to grow at a greater rate than the Australian economy as a whole. The option’s gearing effectively magnifies returns from the underlying investments, whether they are gains or losses. The option predominantly invests in Australian companies and therefore does not hedge currency risk.

I've filled in an application form to invest a further $50,000 in this fund and faxed it to StGeorge margin lending. The investment will be fully funded from the available margin in my account. This will cost around $5,000 pa in additional interest payments, which are tax deductible, but would be partially offset by any distributions from the investment. Of course, borrowing 100% to invest in a geared stock fund is very high risk, but this is only around 5% of my 5% of my net worth. The strategy will pay off if this is a "normal" bear market (followed by a period of good market performance), but won't pay off if we enter a period of extended poor stock market returns, such as occurred the last time we had an oil shock and high inflation in the 70's. Time will tell.





Copyright Enough Wealth 2007

What to do about Margin Calls

Some readers probably have borrowed "on margin" to fund part of their stock portfolio. A margin loan is basically a loan secured against the value of the stocks in the margin account. The lender will determine the "margin" applicable to each stock, based on it's perceived volatility and liquidity. For example, a blue chip stock that is slightly less volatile than the overall market and is highly liquid (traded in large volumes each day) might be allocated a margin of 80%, whereas a small, speculative company with low capitalisation and daily market volume might be given a margin of only 40% (or 0%). The concept is basically the same as a home loan, where the lender may fund up to, say, 90% of the purchase price of a house. As stock prices fluctuate more than house, lenders require a larger "deposit" to buy stocks on margin. [note: this is how margin lending works in Australia, the situation in the US is similar, but different, with generally lower margins being allowed by the regulator).

Margin lenders may "freeze" borrowing against a particular stock if their clients have a large overall holding in that stock. A more annoying behaviour is when a margin lender suddenly decides to reduce the margin allotted to a particular stock when it announces bad news - the borrower then gets a double whammy from both the drop in the stock price and the reduced margin value of that stock.

In times when the market volatility has increased and the market is down (such as now), margin lenders may even make across the board reductions in the margin values of stocks. This reduces the risk to the lender that the stocks may be worth less than the amount loaned against them, but it's pretty poor customer service as it can precipitate margin calls when the market is down and therefore force stocks to be sold when the price is down. Although the loans are secured against the stocks, the lender would still be able to pursue any outstanding debt with the customer, so decreasing margins when the market gets choppy seems too self-serving.

The ratio of the total margin loan balance to the margin value of the stocks in the margin loan account is known as the Margin utilisation (MU). Assuming margins don't change, the dreaded "margin call" will occur if the value of the stocks in the margin loan account drops to the extent that the margin loan balance is more than the margin loan value of the stocks (plus a "buffer" allowed by the lender). The "buffer" allowed by each lender varies, but is often around 5%. In that case a margin call would be made if the MU went above 105% at any time during trading.

When a margin call is made, the customer has a short time (say, until 5pm the next business day) to get their MU back below 100%. When a margin call is made - DON'T PANIC! There are number of ways to handle a margin call, in order from best to worst:

1. Add some extra collateral to the loan account. This is done by transferring some other stocks you may have (that haven't been used as collateral for a loan) into the margin loan account. Assuming these stocks have some margin value, this will reduce the ratio of the loan amount (which stays the same) against the margin value of the margin loan account (which you have just increased). You'd have to negotiate this transfer with the margin lender as it wouldn't be completed within the usual margin call time frame. You should also check that there won't be any capital gains tax issues resulting from the transfer (some margin lenders require the stocks to be held by a trust account, which can be deemed a change in beneficial ownership and thus trigger a CGT event). Because this isn't an instant process, you're probably better to transfer any "spare" stocks into your margin loan account if you get close to 100% MU, rather than wait for a margin call to occur.

2. Use some cash to pay off some of the margin loan balance. This has a big impact on MU.

3. Use some cash to buy some more stock within the margin loan account. This may be attractive if you are cashed up when the market drops, as it may be a good buying opportunity. However, it won't have as big an impact on your MU as option #2 as although you've paid 100% cash for the new stock purchases, only 70%-80% of the stock value (their margin value) with count in the calculation of your new MU.

4. Sell some stocks to pay off some of the margin loan balance. This has the same effect as option #2 from the lenders point of view, but you will be selling off stocks that have probably dropped considerably in price. You get to decide which stocks to sell, taking into account your CGT issues and which stocks you feel should be retained and which should be ditched.

5. Do nothing. The lender will sell some of your stocks to achieve option #4 as soon as the time limit for the margin call has passed. As you don't get to decide which stock they sell off you may not like the result.

If you have a margin loan account is always a good idea to borrow less than the maximum permitted. For example, if the overall margin allowed for the stocks in your margin loan account is 70%, you may just borrow 50% of the purchase cost. This would mean your MU is (50/70) = 71.4%, and the value of the stocks in your margin loan account would have to drop by 32% before you'd exceed a MU of 105% and get a margin call.

It's also good to check your current position and keep an eye on your margin utilisation. A quick "what-if" calculation will show you how much further the market would have to drop before you started getting margin calls.

For example, at the present time (after today's massive 5% plunge, coming on top of 12 straight days of market decline) my margin loans are as follows:

Account #1
Loan balance $166,819
Account value $282,307
Margin value $209,126
MU 79.8%

A further decline of 24% in the overall market would probably see me get a margin call on this account.

Account #2
Loan balance $121,129
Account value $315,189
Margin value $153,908
MU 78.7%

A further decline of 27% in the overall market would probably see me get a margin call on this account.

Account #2 has a much lower overall margin value compared to the value of stocks in the account because this account holds the $100,000 worth of IPE shares I recently bought. This stock has been allocated 0% margin by the lender.

Overall, I have margin loans of $287,947 with an account value currently around $445,047. An further drop of around 25% in the stock market would see me get a margin call. By that time my equity in the portfolios would have dropped from $309,548 to around $157,100 -- so I'd be pretty unhappy. However, with the market already 22% off it's recent high, that would mean an overall market plunge of around 42%, so I wouldn't be the only unhappy investor around.

Copyright Enough Wealth 2007

The Tax Planning Benefits of Investing in Stocks

Over time I've come to the conclusion that I'm not the next Warren Buffet, and given the amount of time I spend "researching" my stock picks I'd probably get better returns over time from my investments in low-fee index funds rather than my portfolio of individual stock picks. However, one significant benefit of investing directly in a diversified collections of stock remains -- tax planning. For example, this year my wife is working part-time and is entitled to some Family Tax Benefit payments from the government, provided our overall taxable income isn't too high. I'm salary sacrificing a large amount of pre-tax salary into my superannuation account this year, so our combined taxable income will be below the threshold provided I don't realise too much capital gains from selling some of my stock holdings this financial year.

At the same time, the Australian stock market is looking a bit choppy, so I would like to sell off some of my stock holdings and use the proceeds to reduce the level of gearing I have via my margin loans. By being able to pick and choose which stocks I sell I can control how much capital gain I realise this year. For example, I recently took up my entitlement to 124,000 IPE options at $1.00. Since then they have paid out a dividend of around 5c per share, and, combined with the overall market correction, they are now down to around $0.91. If I sell off these shares I realise a capital loss of around $11,000 which I can use to offset capital gains realised from selling off some other shares that I have owned for a longer period and have gone up considerably in price since I bought them. That way I can realise some cash to reduce my overall margin loan gearing levels without increasing my taxable income this financial year.

If I later decide that I want to reinvest in IPE for the long term, I can always buy back in to IPE at a later date. Given the global credit concerns I may even be able to buy them in a few months time for less than I've sold them for - they currently appear to be in a bit of a down-trend compared to the overall market:



Copyright Enough Wealth 2007

Time to Think about some more Market Insurance

The Australian stock market has been trading sideways in a volatile manner since mid-year. No-one really knows if the US economy will succumb to the credit squeeze caused by the sub-prime lending fiasco, and draw the global economy into a slump, inducing a bear market. Or whether the US economy will scrape by avoiding recession, and the continue strength of the BRIC economies and Asia will push the Australian market to new highs.

Overall, after several years of double digit returns, I feel it's prudent to reduce my level of gearing from around 60% overall, to a lower level, perhaps even ungeared. However, I don't want to realise any capital gains this financial year (ie. prior to 30 June), so I need to look at some form of insurance against major losses if there is a significant fall in the market before I sell some stocks and reduce my margin loans.

I bought 7 All Ords Index Put options back in June, which would have offset most of my portfolio losses if the market index dropped below 6,500, but the options expire this month. I could buy some similar options that would offset any significant drop in the market (say, more than 10%), for a cost around 2% of my portfolio value. There are other avenues such a warrants, or even using CDFs to short-sell an ETF such as the Commonwealth Diversified Share Fund. I'll have to crunch some numbers to see which how much each alternative would cost to provide similar protection. These choices also have different features. For example, once I've bought XAO put options they would remain 'in force' until the expiry date. If the market rose they would simply decline in value. In contrast, if I sold CDF CFDs and the stock price rose I'd soon face a margin call to keep the position open.

On the other hand, I don't really believe in "market timing", and my investment plan is to remain invested for the long term and to use gearing to (hopefully) produce improved returns (at higher risk) over my investment timeframe. It's just that the series of interest rate hikes over the past few years have raised the interest rate on my margin loans to around 9.5%, which makes it less likely to be a worthwhile strategy (given the long-term overall returns from the Australian stock market are around 9-12% pa). Also, the recent changes in superannuation rules and the ability to invest in CFDs within the tax-advantaged superannuation system, make it attractive to move funds out of geared direct stock investments and into my SMSF. Using negative gearing (outside of the superannuation system) still provides some attractions via the ability to reduce taxable income and "convert" it into long-term capital gains. This is more beneficial than it might appear from simply looking at the income tax rates, as lower taxable income will impact on capital gains tax rates, access to the superannuation co-contribution for undeducted contributions and eligibility to Family Tax Benefit.

Copyright Enough Wealth 2007

How to Halve the Amount of Tax you Pay

Although most readers will know that gearing can be used to increase returns (and risk) of an investment, some may not be as familiar with the benefits of gearing as a tax reduction* tool. This aspects of gearing means that even when rising interest rates make gearing facilities such as margin lending appear unattractive, in reality they can still be a core component of your financial plan. The fact that long term capital gains (ie. a capital gains tax event occurs more than twelve months after an asset is purchased) are taxed at half your marginal tax rate is the key to understanding how this works.

Take, as a example an ungeared investment of $100,000 in a share fund (returning 3% dividend income and 5% capital growth) vs. the same investment increased through the use of a margin loan for the same amount, with an interest rate of, say 6%. Marginal tax rate is assumed to be 30% and dividends fully franked. Net value is calculated at the end of a "typical" year:

            Ungeared      Geared
Equity      $100,000.00   $100,000.00
Loan              $0.00   $100,000.00
Total       $100,000.00   $200,000.00
Dividend      $3,000.00     $6,000.00
Franking Cr   $1,285.71     $2,571.42
Cap Gain      $5,000.00    $10,000.00
Interest          $0.00    -$6,000.00
Inc Tax      -$1,285.71      -$771.42
CG Tax         -$750.00    -$1,500.00
Net Value   $107,250.00   $110,300.00

As expected, where the margin loan interest rate (6%) is less than the total return (8%) from the investment, gearing increases your gains.

What is interesting though, is that gearing is still beneficial when the interest rate on the loan is as much as the total return on the investment (8%):

            Ungeared      Geared
Equity      $100,000.00   $100,000.00
Loan              $0.00   $100,000.00
Total       $100,000.00   $200,000.00
Dividend      $3,000.00     $6,000.00
Franking Cr   $1,285.71     $2,571.42
Cap Gain      $5,000.00    $10,000.00
Interest          $0.00    -$8,000.00
Inc Tax      -$1,285.71      -$171.42
CG Tax         -$750.00    -$1,500.00
Net Value   $107,250.00   $108,900.00

This happens because the use of gearing is effectively 'converting' taxable income into taxable capital gains, which provides a superior after tax return.

Of course gearing also magnifies any losses, so this "tax effect" is only a consideration if you are reasonably sure the total return on your investment will be at least match the cost of funds borrowed over the long term. For this reason I prefer to use margin lending to fund a diversified share portfolio, preferably with a core holding of an index fund.

It's also important to be reasonably conservative in your gearing levels so that normal market volatility and 'corrections' won't trigger margin calls. Although it's hard to correctly 'time' the market, it's probably also prudent to reduce gearing levels when the market is well above it's long term trend line, and thereby have some spare borrowing power available to add to your investments at the end of a bear market if the index is well below it's long term trend. It's also worth shopping around to find the best interest rate available for a margin loan, as there can be a significant difference between lenders. It's also worth reading the fine print, as you may be able to negotiate a reduced rate on large loan balances. For example, I get a slight discount on the standard margin loan rate from St George margin lending as we have a large home and investment property loan with them and thus qualify as 'gold' customers.

* I use the term 'tax reduction' as it seems to be the most acceptable terminology to use these days in regards to tax planning. Although tax evasion is illegal and tax avoidance/tax minimisation is, by definition, legal, there has been a trend towards vilifying and legislating against "tax minimisation schemes" and "tax avoiders". On the other hand, politicians on both sides revel in passing laws to facilitate 'tax reduction' through reduced tax rates, increased thresholds or expanded deductions, so it seems to be the PC term to use in relation to paying as little tax as possible.

Copyright Enough Wealth 2007

Reducing Tax by Pre-paying Margin Loan Interest

As the end Australian financial year draws to a close on 30th June, it's time to make arrangements to pre-pay up to 12 months interest on my margin loans. I owed $116K to Comsec, so I prepaid the next 12 months interest on $100K of the balance. I also took up the option to capitalise the prepaid interest. I had some other funds sitting in online savings accounts, so I used that money to repay the remaining $16K of variable rate margin loan. This will mean that I don't have to make monthly interest repayments on the Comsec account for the next 12 months.

I expect I'll soon receive the paperwork to prepay interest on my other margin loan account with Leveraged Equities. I currently have $150K prepaid with them, which I'll reduce to $140K as I have around $6K sitting within the cash management account in my LE due to recently selling my Qantas shares. I'll put that money towards the interest prepayment, so I'll only have to come up with another $6K for the interest prepayment. This will leave only a few thousand dollars of margin loan debt requiring monthly interest payments.

One benefit of making the interest prepayment is that you get a slightly lower interest rate than the monthly variable rate (but this is offset by the opportunity cost of the prepaid interest amount for an average of 6 months). But the main benefit is that you bring forward the tax deductible interest expense by 12 months, so you gain an extra tax deduction the first year you do this. However, each subsequent year you are simply using the prepayment of the next year's interest to substitute for the current year's interest (that was prepaid the previous tax year). At some time in the future you have to unwind the prepayment arrangements by having a year with no tax-deductible interest payment, or possibly a series of years with slowly decreasing interest deductions. I plan to schedule this to occur when I'm retired and over 60. At that time (under the new Simpler Super rules) I'll be living off tax exempt Superannuation pension income, so the tax I pay on any dividend income from my margin loan portfolio will be very low, so getting the tax deduction for interest payments will no longer matter.

Anyhow, interest prepayment on margin loans is just the "icing on the cake" - the main benefit of using margin loans is to get a bigger stock portfolio, but have tax deductible interest payments slightly larger than the dividend income from the portfolio. This basically means that you have no net taxable income from the stock portfolio, and instead only make capital gains on the portfolio. If the gains are on assets held more than 12 months before sale, the applicable tax rate is half your marginal tax rate.

Enough Wealth

Is it Better to Invest 100% in Stocks or to Gear a "balanced" Portfolio?

I happened to come across the website for Shearwater Capital the other day. Their investment approach seems sensible and their published fees reasonable, but that isn't what caught my eye. I was more interested in their model portfolios and using the data on the 20-year performance to evaluate the effectiveness of gearing as an investment strategy.

Looking at their "Aggressive" portfolio (80% stocks/20% bonds, which is similar to my target asset allocation) you have a Twenty Years Annualized Return of 12.3% with a Thirty Three-Year Model Annualized Standard Deviation 11.8%. The "Very Aggressive" portfolio (100% stocks) has a Twenty Years Annualized Return of 13.7%, but the Thirty Three-Year Model Annualized Standard Deviation shoots up to 14.6%.

This shows that, as can be expected from modeling of the efficient frontier of a portfolio composed mainly of stock and bonds, the optimum return-risk outcome is achieved from a portfolio comprised mostly of stocks, but with some bonds included. The mix within the stock component is usually around 60% domestic:40% foreign, although in various ten-year periods you would have done better with the opposite ratio (so a 50:50 split may be a good bet).

Moving from the "Aggressive" to "Very Aggressive" asset mix boosted returns by 11.38%, but the "risk" (variability of returns, as measured by the Standard Deviation) increased by 23.73%.

For this reason, if you are seeking higher returns over long time periods, it seems a better strategy to use gearing of an "Agressive" portfolio, rather than moving to a "Very Agressive" portfolio.

Taking the Twenty Years Annualized Return of the "Very Conservative" portfolio (100% bonds) as a proxy for the interest rate cost of gearing (via margin loans or a real-estate backed investment loan such as a HELOC), one can make a rough estimate of the Twenty Years Annualized Return and Thirty Three-Year Model Annualized Standard Deviation that would result from a 100% geared (50% LVR) "Aggressive" portfolio:

                        20-year       33-year
                        Annualized    Annualized 
                        Return        Std Devn
Ungeared "Aggressive"   12.3%         11.8%
Estimated Cost of Loan  5.9%          2.4%
Estimated 100% geared   18.7%         23.6%
Estimated 22% geared    13.7%         14.4%       
Ungeared "Very Aggres." 13.7%         14.6%

Using gearing could therefore increase your average returns by 52.03% at the cost of increasing standard deviation by 100%. This is somewhat better than shifting your asset allocation from "Agressive" to "Very Aggressive". However, the absolute "risk" has increased 100% compared to 23.73%, so the strategy of making use of 100% gearing ratios should probably be called "Hyper Aggressive". A more modest use of gearing (say, 22%) would produce similar average return as a "Very Aggressive" asset allocation, but with a slightly lower standard deviation.

It was interesting to see that the returns for the 100% geared "Aggressive" portfolio are very similar to the long-term increase in value of my own investment portfolio. When I started out I didn't use gearing and had a more conservative asset allocation, but this was offset by the relatively large impact my savings had at that stage. These days my savings have a more modest impact on my overall increase.

One final note, when using gearing the cost of funds (interest rate and any annual fees) can have a major impact on the long-term performance of this strategy, so it is worth shopping around.

Enough Wealth

Using Contracts for Difference (CDFs) to trade US stocks

I've been building up a portfolio of US stocks (my "Little Book" portfolio) since the middle of last year. One of the problems of trading US stocks from Australia has been the relatively high brokerage costs - using Comsec-Pershing it costs AUD$65.00 per trade. E*Trade Australia charges even more, and I haven't been able to find any Australian brokers that will trade US stocks more cheaply. Some readers have recommended US-based brokers which are cheaper, but before I take that route (with the associated hassles around transferring funds in USD to a US brokerage before making trades) I've decided to experiment with using Contracts for Difference (CFDs). These are quite a popular tool for day traders, as you can gain market exposure with low costs per trade (as little as $1) and trading CFDs has a built-in gearing effect (usually the trades are based on a margin of between 5% and 20% of the stock value being traded). I don't intend to try day trading (I think it's a zero sum game, which generally just transfers wealth from the casual day trader to commercial traders), but it looks like it may offer a cheaper method to implement by US stock portfolio strategy.

I applied online for an account with CMC Markets on Friday, and today their representative phoned to request a fax of some identification (drivers licence and a rates notice) to finalise opening my account. As soon as this is processed I'll be sent a login and can transfer the initial $1000 required to begin trading. Although there is a normally a monthly fee of around $40 to use their trading software with live stock price data from the ASX, as I only intend to trade US stocks this data isn't needed and I won't have to pay any monthly fee.

Trades of US stocks are generally on a margin of 5%, so I should be able to buy a CFD to gain equivalent exposure to a US stock as my Comsec-Pershing $5000 trade for only $250. The minimum fee of $10 is high as a percentage of the trade value (4%), but is very reasonable compared to the underlying stock exposure (0.2% of $5000). I'm not sure that all the US stocks I've picked for my "Little Book" portfolio would be available as CFDs - only 541 "constituents" of the US market are available from CMC markets.

There's also a fundamental difference between buying stocks and trading CFDs - in the case of CFDs you are basically buying a promise from the issuing company, in this case CMC Markets. The CFDs issued by CMC Markets are not tradeable by any other CFD company, and if CMC Markets went out of business my investment in their CFDs would be worthless.

Anyhow, to replicate my actual US stock trades with Comsec-Pershing over the next 12 months (US$60K worth) will only cost me around US$3K to buy the equivalent CFDs, so it's not going to be a hugely expensive experiment whatever happens. If it works out I could save US$600 a year in trading costs, which would add directly to the ROI of my "Little Book" portfolio.

Enough Wealth