1. Learning Objectives
After studying this powerpoint you should be able to:
Explain the concept of leveraged investing
Outline how gearing can be used to magnify returns
Discuss the income tax consequences of gearing
Discuss the capital gains tax consequences of gearing
Explain how mortgages work
Outline margin lending
Explain the benefits and risks of margin lending
Outline how derivatives can be used to create leverage.

2. Introduction
Leveraged 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.
Leveraging can also refer to the use of derivatives (futures, options and warrants) to create an exposure to significant gains (or losses).

3. Leveraged investing
Leveraged 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.

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

5. Income taxes and geared investments
Dividend, interest or rental income is assessable for tax purposes
Interest expense on a loan for the purpose of investing in income producing assets will be a deductible expense
This will be the case whether the investment is positively or negatively geared

6. Income taxes and geared investments
Also work out if you had a capital loss and less rental income!!
Table 8.1 Kevin: no taxes, and returns > costs

7. Positive gearing
Positive 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

8. Negative gearing Negative gearing occurs
where an investor buys an income producing asset using borrowed funds, and
the 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

9. Negative gearing example:
Kevin has assessable income of $20,800 and allowable deductions of $21,600 from an investment thus leaving an $800 loss
If 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

10. Risks of negative gearing
Anticipated annual income is lower than expected
Anticipated expenses are higher than expected
If a lender changes the terms of a loan this may affect the benefits of negative gearing
A reduction to the investors other income could lower their marginal personal tax rate making the tax shield less attractive
The investor is forced to sell at the wrong time in the market cycle
Asset specific factors e.g. bad tenants
The asset does not generate the capital gains anticipated

11. Gearing ratio
Gearing ratio is used to measure amount of debt in relation to current market value of asset purchased with debt.
where
Gearing ratio = Borrowed funds Investor’s contribution
Investors contribution = market value of asset – borrowed funds

12. Table 8.5 Kevin: gearing ratios

13. Capital Gains Tax (CGT)
Date of commencement of the CGT was 19 September 1985
Assets acquired after 19 September 1985 and before 21 September 1999 generally allow the taxpayer to select either the indexation method or the discount method
Assets acquired from 21 September 1999 generally require the taxpayer to select the discount method to apply to any capital gain
The 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

14. CGT
Capital losses may only be claimed against capital gains – if there is no capital gain in the year that a capital loss is incurred, the loss may be carried forward
An advantage of shares is that only a part of a share portfolio may need to be sold thus limiting capital gains whereas real estate is a ‘lumpy’ investment

15. Mortgages
Mortgage – a contract between a lender and a borrower which pledges real estate as security for a loan
Most common types of mortgages:
Standard variable-rate loans (SLV)
Fixed-rate loans
Variations allowed with deregulation:
Interest-only loans
Equity release loans
Reverse mortgages (Home Equity conversion loans)
Second-mortgage loans
Fixed-rate loans have fixed rates of interest for an agreed period of time. At the end of this period they generally convert to variable-rate loans.
Reverse mortgage - a 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

16. Margin lending
Margin lending – lending for investment where the loan is secured by the investment
Borrower must maintain a loan-to-value ratio (LVR) which is set at the beginning of the loan
Loan-to-Value Ratio = Debt
(LVR) Current market value of the
investor’s contribution + Debt
- LVR will change as the value of investment portfolio changes

17. Margin lending continued
Most lenders require investors to maintain a safety margin above the value of the loan
A margin call will be triggered if the value of the security falls below the value required by the lender
Margin calls have to be satisfied within 24 hours (refer to illustrative example 8.2)
Safety margin = 1 – Borrowing
Security recognised by lender
A margin call is where the lender asks for an additional contribution by a borrower because the current level of the security they are offering has fallen below an agreed threshold.
Margin calls can be satisfied in 3 ways:
The borrower contributes cash until the desired LVR is achieved
The borrower adds new security to the portfolio
The borrower sells some of the current security in the portfolio and pays back some of the loan

18. Margin lending continued
Table 8.7 Selected LVRs for CBA margin lending as at 1 April 2013
Note: Portfolio LVR is applicable to stocks in a diversifi ed portfolio with 5 or more approved securities.
Source: CommSec

19. Margin lending continued
BENEFITS
Greater access to wealth-creating assets
Diversification
Liquidity
Personal income tax benefits
Direct investing and management
RISKS
Capital losses
Funding interest payments
Funding margin calls
Fluctuating value of the portfolio

20. Derivatives
Derivative – a financial product whose value or price is derived from some other asset
Derivatives include:
Contracts for difference
Futures
Options
warrants

21. Contracts for Difference (CFD)
An agreement between a buyer and a seller to exchange the difference in value of an underlying asset
The buyer is going long and expects the price of the underlying asset to rise
The seller is going short and expects the price of the underlying asset to fall
ASX or over the counter (OTC) CFDs
Can also be used to hedge a physical position

22. Futures contracts
A futures contract is an agreement to trade an asset 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

23. Futures contracts continued
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

24. Futures contracts continued
Example
Date Trade Investment
4 Jan Buy 1 gold contract with a speculation of 1000oz.
Settlement date: 15 March
Purchase price: $520 per ounce
Value of contract: $
Deposit: 10% of market value – $52 000
10 Mar Gold price increases to $536 per ounce
Value of contract: $
Sell futures contract at $536 & lock in profit of:
$ – $ = $ $16 000
Deposit returned $52 000

25. Futures contracts continued
Realised return
Capital used:
At beginning $52 000
Add profit $16 000
At end $68 000
r = $ – $ x $52 000
= 30.77%

26. Futures contracts continued
Other issues to consider in relation to futures contracts are
Margins and deposits
The futures exchanges
The clearing house of futures exchanges
Novation

27. Futures contracts continued
BENEFITS
RISKS
Liquidity
Funding of margin calls
Credit security
Market volatility
Flexibility
No income stream
Knowledge risk

28. Options
An 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 price
Buyer of option has no obligation to buy/sell if market price is below the option price
Seller has an obligation to complete the transaction
Two types of options
Put options
Call options

29. Options continued Rights of option buyers and sellers Type of Option
Buyers’ Rights
Sellers’ Obligations
Call options
Choice of buying underlying security or asset
Must sell underlying security or asset if option exercised
Put options
Choice of selling underlying security or asset
Must buy underlying security or asset if option exercised

30. Options continued
Brokers work out the amount to charge for the premium of an option on a financial asset based on: risk, liquidity, time to maturity, volatility, etc.
Options 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

31. Options continued
Pay-off profiles for the buyer and seller of a call option

32. Warrants and other complex leveraged investments
Warrants are leveraged investments in the shares of a company.
Traded on the ASX
Issued in a series
Endowment and instalment warrants are not issued by the company in which the shares are being bought, but by a third party institution

33. Warrants and other complex leveraged investments continued
The 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 fall
Warrants can be broadly categorised as:
Trading style (higher risk / return attributes) or
Investment style (lower risk / return attributes) and includes endowment and instalment warrants which are effectively a long term loan to buy shares

35. Summary
Leveraged investing is an effective use of small amounts of investment capital to magnify returns
It refers to either the use of borrowed funds or the use of derivatives
Leveraging is increasingly common in a personal investment portfolio.

36. Summary continued
Leveraging is reliant on expected returns, ability to service debt and tax advantages.
Leveraged investments come with a number of investment risks.