1. Topic 6 – Leveraged Investments BAFI 1016 Personal Wealth Management

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. There are two main methods of leveraging: borrowing and using the futures and options market.

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 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. Gearing describes the use of borrowed money to buy investment assets and achieve a return greater than the cost of using the borrowed funds.

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. 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.

7. 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.

8. 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

9. 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 eg bad tenants The asset does not generate the capital gains anticipated…

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

11. Capital Gains Tax (CGT) Date of commencement of the CGT was 19 September 1985 Assets acquired after 19 September 1985 and 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

12. CGT Capital 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 forward An 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

13. Mortgages 3 ‘normal’ different types of mortgages: –Level payment fixed-rate mortgage –Graduated payment mortgage –Adjustable-rate mortgage Variations allowed with deregulation: –Interest-only loans –Bullet payment loans –Development loans –Equity release loans –Home Equity conversion loans –Second-mortgage loans

14. Reverse Mortgages …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

15. Margin Lending Margin 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.

16. 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

17. Derivatives Contracts for difference Futures Options warrants

18. Contracts for Difference …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 OTC CFDs Can also be used to hedge a physical position

19. 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.

20. 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.

21. Futures Contracts 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: $520 000 Deposit: 10% of market value – $52 000 10 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 + $16 000 Deposit returned + $52 000

22. Futures Contracts Realised return Capital used: At beginning$52 000 Add profit$16 000 At end$68 000 r = $68 000 – $52 000 x 100 $52 000 = 30.77%

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

24. Futures Contracts BENEFITS Liquidity Credit security Flexibility RISKS Funding of margin calls Market volatility No income stream Knowledge risk

25. 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

26. Options Type of OptionBuyers’ RightsSellers’ Obligations Call optionsChoice of buying underlying security or asset Must sell underlying security or asset if option exercised Put optionsChoice of selling underlying security or asset Must buy underlying security or asset if option exercised Rights of option buyers and sellers

27. 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, volatility 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

28. Other Complex Leveraged Investments - Warrants 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

29. Warrants 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

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

31. Overlapping Suitability of Derivative Products …an investor could find themselves in a position whereby they could pursue the same investment opportunity via a number of different derivative products

32. Summary Leveraged 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.