Recent Instances in Australia of Margin Lending Disaster - Case Study Example

Financial Planning (Deakin University MAF255) Recommendation Letter Dear Mr. Tony Bradfield. On the assumption that you sell your investment in the managed fund at the end of two years, the following report is prepared for you to made an informed decision on terminating your Managed Fund investment. Any of the three alternatives will probably boost your retirement savings, and your investment will affect his tax liability under each of the following three funding alternatives. The first alternative, investment will utilise the maximum amount of funds available under the ANZ banks margin lending facility with a net gain of $4,580.79. The second alternative, all the funds from your own capital, will generate a net capital gain of $6,028.00. Lastly, the third alternative is a combination of funds – 50% from the ANZ banks margin lending facility and 50% from his own capital which will generate a capital net gain of $5,308.56. Based on the above capital gains computation, you can choose the one of the three options based on your personality. If you live for danger, option 1 is good. If you feel too timid, option 2 is preferable. Lastly, if you prefer the walk the middle ground between old paths and innovative danger, option 3 is a good alternative. Please see attached documents for net present value, and interest on margin loan computation. Signed You financial analyst / Investment consultant TABLE OF CONTENTS Title Page Title Page 1 Recommendation Letter 2 Table of Contents 3 Introduction 4 Comprehensive Overview of How Margin Lending Works. 4 One example of Recent Instances In Australia of Margin Lending Disaster 7 Comprehensive Overview of investing in Managed Funds 8 Recommended Managed Fund Appropriate for Tony Bradfield 11 Tony’s Decision to Use a Margin Lending Facility 12 Conclusion 15 References 16 Introduction In terms of margin lending, one of the many investments funds in Australia is classified as managed funds. The client, Tony Bradfield is 47 years of age, and wants to invest exactly $100,000 in a Managed Fund, with the specific goal of boosting his retirement savings, as he believes that he will not have enough in his retirement fund at 65, when he plans to retire. Financial research offers the best option to fill Tony Bradfield’s investment temperament. Comprehensive overview of how margin lending works. There are many options to augment Tony Bradfield’s retirement cash inflows. The first option is for Tony Bradfield to invest his own savings of $100,000 on which he currently earns 4.5% before tax per year to invest in management funds. The individual will earn $4,500 for one year for a total of $9,000 for the entire minimum requirement of two years investment. This is the most safe investment alternative - the investor is assured of the $4,500 cash inflow with no probability of losing the $4,500 a year unlike the other two options discuss in the next paragraphs (Haydock 2006; 91). Another investment option of the client, Tony Bradfield, is the use of a margin –lending facility. An individual borrows money from the banks or other financing organizations to invest in a managed fund. The individual uses the loan to invest in a project generates more than enough cash inflows to pay for the principal amount loan and the additional interest component of the loan contract. In this scene, there is strong probability that the invested money may not be enough to cover the loan amount and interest payments especially when adverse economic conditions. In the same manner, an individual may enter into a legal contract between a broker and oneself where the individual may borrow money from the broker for investment reasons. The individual, Tony Bradfield, trades on margin with the broker that he will pay the margin call amount and other collectibles when the time for payment arrives (CCH 2009;492). On the other hand, the probability of generating losses from investing in managed funds is one disadvantage of using the services of margin –lending facilities. There is similar probability of generating margin –lending loss as there are margin –lending gain in patronizing margin –lending facilities like ANZ bank. Tony Bradfield may be required to infuse more margin call funds to comply with the required margin loan agreement (National Book Council, 2008; 52). A third option of the client, Tony Bradfield, is to venture into hybrid investment. Hybrid investment includes a combination of a margin loan and personal capital investments. Being an aggressive investor, Tony Bradfield can investment half of the $100,000 in the bank for two years. Tony will earn $1,125 per year ($50,000 x 4.5 percent). Thus, Tony will be assured of receiving a total of $2,250 for two years. Tony can invest in the stocks the balance of $50,000 to generate profits from margin lending. There are many advantages of choosing the third option. Another term for the third option is diversification. The goal of undertaking diversification is to minimise managed fund risk exposure without sacrificing risk-adjusted returns (Bouris 2008;167). Diversification includes investing across managers. The strategy is active or passive investment approach, index-linked portfolio management, sector specific skills, and with a tactical asset allocation via market timing. As discussed in the prior alternative, investing in margin lending facilities may be costly if the stock market price or commodity price moves unfavorably against the investor, Tony Bradfield. In this case, the stock market broker may be forced to call Mr. Tony Bradfield, the investor, to invest more cash or margin security deposits to comply with the minimum requirements set forth by the stock exchange for the investment or short sale of securities and commodities to cover for adverse price movements of the stock market or commodities market (Janakiramanan, 2007; 448). A sample margin call computation is shown as follows: an investor invests in for a $100,000 Treasury Bond contract. Point value is $31.25 per tick and one full point equals 32/32nds or $1000. Initial Margin: $2700 Maintenance Margin: $2000. News spreads like wildfire that announced on CNN states that the government had just lowered interest rates and feels the softening economy might warrant further cuts to avoid a recession. The economic guru in you thinks this will be the case and you quickly establish a position in the CBOT T-Bond market and buy two December contracts at a price of 9500. Mr. Bradfield may feel that interest rates will fall in the future generating an increase in the market price of my T-bond contracts and a hefty profit. The settlement price at the end of the day is 9510. (http://www.devnic.com/tutorials/how_margin_commodity_futures.html). In terms of the following day you have an initial margin call, based on the settlement price of 9510 you have equity of $625. That's the difference of your trade price of 9500 and the settlement price of 9510. The calculation looks like this: 10 X $31.25 = $312.50 X 2 contracts = $625. Your broker calls you and issues you an initial margin call of $5400. $5400 is derived from your position of 2 T-bond contracts with an initial margin requirement of $2700 per contract. The calculation looks like this: $2700 X 2 = $5400. If the funds were deposited on that day your account would have a total equity of $6025. That equals the initial margin deposit of $5400 + unrealized gain of $625 (http://www.devnic.com/tutorials/how_margin_commodity_futures.html). One example of Recent Instances In Australia of Margin Lending Disaster Tricom was delayed in fulfilling its stock market trades with the Australian Securities and Exchange Commission after its stock market price declined. For clarity, an investor who invests (bids) in a Tricom stock on a Monday at $ .05 per share generates a loss if it is sold (offered) the following day at $.045 per share by $.005 per share. On the other hand, the investor generates a gain if the next day’s offer price ($5.70) is higher than the investment price generating a profit of $.70 per Tricom share of stock. In response, ANZ (Tricom’s creditor) instructed Tricom manager, Lance Rosenberg, to lessen its broker’s margin by hundreds of millions of Australian dollars to comply with its margin –lending loan agreement with its stock market brokers. Consequently, Tricom’s main creditors, ANZ, Credit Suisse, and Merrill Lynch automatically froze all of Tricom’s assets to ensure that the assets will were used to comply with its margin lending requirements. Tricom was forced to sell its invested shares infused by its investors. As expected, Rosenberg called a meeting of 300 Australian Stock Market dealers to require them to force the broker’s clients with Tricom stocks to refinance their margin –lending investments. (http://www.theaustralian.com.au/business/markets/banks-put-squeeze-on-tricom/story-e6frg916-1111115437204) Comprehensive overview of investing in Managed Funds The chapter on Managed funds investment indicates that is an indirect investment strategy in assets under the expert handling of a person managing the fund. The management fund includes the choice of assets that Mr. Tony Bradfield may choose to invest. The manage fund typically has a managed structure. Tony Bradfield will have to comply with the regulatory requirements when investing in management funds. Mr. Tony Bradfield’s choice of a pooled investment structure a managed fund will provide him with the potential to benefit from decreased investment costs, decreased investment risks, and increased investment returns. In addition, the managed fund structure offers benefits for Mr Tony Bradfield to access one or all of the asset classes, sub-categories of asset classes, or a particular asset mix of asset investment alternatives (Beal & McKeown,2006) . Further, the manage funds can be either listed or unlisted. It is more popular for property-based managed funds to be listed than managed funds holding other asset classes because of the effects of valuation and liquidity issues. There is significant growth of the managed funds industry in Australia starting 30 years ago. The main influencers of the increase in management funds investments in Australia include the deregulation of the financial markets commencing in the early 1980s. It also includes government incentives and legislation affecting superannuation funds since the early 1990s (Beal & McKeown,2006). Another advantage is the influential presence of the three managed funds pillars to ensure fairness and smoothness among all parties concerned. One of the pillars is the ASIC. The organization takes a watchful eye on the transactions under the managed fund industry by ensuring compliance with the Corporations Act. The ASIC also regularly issues policy statements and proposals outlining changes and highlighting areas of concern including changing trends. Another pillar is the APRA. The organization supervises banking and financing industry. The organisation also regulates the superannuation funds via Superannuation Industry (Supervision) Act (SIS). A third pillar is the RBA. The organisation monitors broader economy via monetary policy (Beal & McKeown,2006, chap 6). Another advantage of the managed fun is the presence of a responsible entity or RE in the transactions. The Responsible Entity (RE) acts both as managed fund trustee and manager. The entity is a trustee in ensuring managed fund assets are held in the name of the Responsible Entity. The entity is required to operate as a public company Australian Financial Services Licence holder. It is also required to maintain a specified minimum level of net tangible assets (Beal & McKeown,2006, chap 6). A further advantage is the fact that the Australian constitution should be part of the establishment of a managed fund which outlines the: process of admitting and withdrawing investors including the basis of assessing investment pricing for, Investment powers of the RE, and complaints resolution process. Another advantage is the importance of compliance plan in providing operational details of how a managed fund will meet its regulatory and constitutional compliance obligations (Beal & McKeown,2006; chap 6). Another advantage of management funds is that unit holders are fund investors who are the beneficiaries of the investments undertaken by the managed fund. The management fund investors share in cash and stock dividend distributions made by the managed fund. An ANZ dividend declaration of $1 per share would entitle Mr Tony Bradfield a $1 dividend income for every share of stock he invests in. A further advantage is that managed funds provide investors with a greater choice of assets than direct investing. The managed funds help investors build a diversified portfolio of investments (Moles 1997; 26). One major disadvantage of investing in management funds is to probability of losing money due to adverse investment conditions. Investing in an asset that drops in value after several years would surely be a poor investment story. People who invested in United Companies like Washington Mutual, Lehman Brothers suffered losses form their management fund investments. The above companies closed shop after their stock market prices plummeted due to adverse economic conditions (Richards 2002; 41). Based on risk profiles of managed funds, investing in cash (Bank deposit at 4.5% interest) has a low risk for a one year or less investment. In addition, investing in fixed interest government bonds has a low risk if invested for a period from one year to five year periods. Likewise, investing in property (real estate) will have a medium risk when invested for five to ten year periods. The shares of stocks have high risk when invested in a five year to ten year period. Investing in balanced funds (all asset classes) will have a medium risk if invested for a one year to five year period (Richards 2002; 41). Likewise, investing in diversified investments have a high risk when invested for a period of one year to five years. Investing in international foreign assets would entail a high risk when invested for a five year to ten year period. Hedging investment money in two or more funds would entail a high risk because the it would be difficult to estimate the feasible number of years to invest Tony’s P100,000 or less investment (Richards 2002; 41). Recommended Managed Fund Appropriate for Tony Bradfield The best management fund alternative, option 3, fits Tony’s temperament. Tony could should invest $50,000 in the bank (cash management) because of the low risks. The money in the bank will earn interest at 4.5 percent per year. Tony should also invest the remaining $50,000 in property managed funds because of the medium risks involved. Investing in real estate is a very profitable investment because land values will continue to rise (English 2003;52). However, a letter will be sent to Mr. Tony Bradfield to have the final decision base on his temperament. This includes the initial intention of Mr. Tony Bradfield to implement option 1 (margin lending facility use). Tony’s Decision to Use a Margin Lending Facility • The investment will utilise the maximum amount of funds available under the ANZ banks margin lending facility.   PAYMENT PAYMENT PAYMENT       interest   Principal Yr Interest todate Principal Balance 1 724.17 724.17 155.72 99844.28 2 723.04 1447.21 156.85 99687.43 ANZ margin lending $100,000 x 8.69 percent for 20 years. (http://www.infochoice.com.au/investment/investment-broker/anz/anz-margin-loan/5021) The following is the 2 year (monthly) stock prices of ANZ bank ending May 7, 2010. $22.6 as of May 10, 2010 (http://www.marketwatch.com/investing/stock/ANZ/charts?CountryCode=au) Based on the technical chart shown above of ANZ stocks for the past two years ending May 7, 2010, it is projected that the stock price of ANZ Stocks on May 6, 2010 will be $ 24.00. The above technical chart is a one of the best tools for projecting that ANZ stocks will generate positive returns, growth, and higher price in terms of managed funds. However, other factors like the GDP, inflation, deflation, bank lending rates, and unemployment rate will influence the returns, growth, and price movement in terms of ANZ managed funds. Assuming the stock market price, base on the chart technical analysis above, ends up with $24 two years later on May 6, 2010. Investment Stock Stock Shares Capital   Market Market   Gain   Price Price     $100,000 22.63 24 4400 6,028.00   May 7,2010 May 6, 2011     $100,000 invested in 4,400 ANZ shares of stocks sold year 2. Capital gain 6,028.00 Interest expense 2 years 1,447.21 Net gain 4,580.79 • All the funds from his own capital Capital gain (2 years) 6,028.00 Interest expense ( 2 yrs) - Net gain 6,028.00   6% after tax rate of return     Pres Val 100,000 1.124 112400 Cost     100000 Net PV     12400 The net present value of $100,000 invested at after tax rate if 6 percent and sold after 2 years is $12,400. • A combination of funds – 50% from the ANZ banks margin lending facility and 50% from his own capital. (5 Marks) Cash Investment $50,000   PAYMENT PAYMENT PAYMENT       Interest   Principal Yr Interest to date Principal Balance 1 360 360 78.35 49921.65 2 359.44 719.44 157.85 49842.73           $50,000 ANZ loan for 20 years sold after 2 years. Capital gain ( 2 yrs) 6,028.00 Interest expense (2 years) 719.44 Net gain 5,308.56 Pres Val 50,000 1.124 56200 Cost     50000 Net PV     6200 The net present value of $50,000 invested and sold after 2 years is $6,200 with after tax rate of 6 percent. BRIEFLY, one of the many investments funds alternatives in Australia is the investment in management funds. Superannuation is another fund type. The client, Tony Bradfield,47 years of age, and wants to invest exactly $100,000 in a Managed Funds. He can prefer to choose one of three alternative options. Indeed, financial research offers the best option to fill Tony Bradfield’s investment temperament. REFERENCES Australian_Bureau_of_Statistics. YearBook Australia . Australia: Australia Bureau of Statistics, 2005. Bouris, M. Yellow Brick Road to Your Financial Secuity . Australia: Allen & Unwin , 2008. CCH. Australian Master Financial Planning Guide 2009/10 . Australia: CCH Australia, 2009. English, J. New Australian Stockmarket Investor. Australia: Allen & Unwin, 2003. Haydock, A. Social Security and the Stock Market. Australia: W. E. Upjohn Institute, 2006. Moles, P. The Handbook of International Financial Terms. Oxford: Oxford University Press, 1997. National_Book_Council. Australian Book Review. University of Michigan: P Isaacson Press, 2008. Richards, A. All About Exchange Traded Funds. Australia: McGraw Hill Press, 2002. S Janakiramanan. Derivative Securities and Risk Management in Asia and Australia. Los Angeles: Pearson Prentice Hall, 2007. Marketwatch, retrieved May 10, 2010. From Margin lending, retrieved May 10, 2010, from The Australian, retrieved May 10, 2010, from Read More