While the markets may be down now, some investors may want to take a chance and enter the markets. With this, investors may be able to ride the recovery wave when rate hikes from the US Federal Reserve (US Fed) taper off.
However, some may be thinking that they may not have much to invest, and to put a small sum in the markets for a small return may not be worth the risk.
Traditional investment rationale says that the more one invests, the more absolute returns one should be able to get, assuming all remains equal.
If one puts in $1,000 into a stock giving a dividend of 4% per year, they will receive $40. If one invests $100,000 in the same stock, and nothing changes, that’s an absolute return of $4,000.
Of course, the markets constantly shift, but the principle remains generally true.
The question is then, can one put the same amount of money into the markets, and yet, get a larger investment return?
One way would be to borrow money and invest the total amount. But with rising global interest rates, one could end up in a situation where the interest paid on the borrowed money will be higher than any potential total returns.
A quick check on personal loan rates reveals that they can have an effective interest rate of anywhere from 6% to above 11% per annum (p.a.), which can be hard to surpass.
This is where an arrangement called share financing comes in. Simply put, the investor borrows money from a brokerage, using shares or cash as collateral, and invests the total amount. The brokerage would charge an interest on the amount borrowed.
In short, what share financing allows is that an investor can enlarge their investment exposure, but at the same time, not commit additional liquidity.
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But, many investment guides will tell investors to “only invest money you can lose” and to “take care of your bills before you get into investing”. So, doesn’t the idea that one should borrow to invest seem counterintuitive?
How share financing works
To understand this investment strategy, a quick understanding of how share financing works is in order.
For an investor to borrow this money, one needs to put up collateral with a brokerage that offers such an arrangement. A share financing arrangement usually allows a customer to leverage their investment, i.e. to use borrowed money and enlarge their investment position.
Take an example where a brokerage allows a leverage of 3.5x. Should an investor put $1,000 in cash into a stock under this arrangement, one can have an investment exposure of up to $3,500, with the brokerage loaning the remainder.
Take a scenario with a fictional investor named Bob. For example, if Bob invests $1,000 in cash with a 5% capital gain, this would mean that Bob will get a total of $1,050, an increase of $50.
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But with a $3,500 investment position given the 3.5x financing, and with the same rate of return, that means a $175 gain for Bob, for a total of $3,675, implying an effective return of 17.5% on the $1,000 placed in the share financing arrangement, before deducting share financing costs.
But if this arrangement is so good, what’s the catch? Of course, the mantra of "high risk, high reward" still holds. When trading on leverage, one needs to maintain what is known as an assigned "margin ratio" with the brokerage.
Back to Bob and his $1,000. So, if Bob puts in $1,000 into the share financing arrangement, he will be able to leverage a total investment position of $3,500, which is a ratio of 350%.
Say the brokerage assigns him a margin ratio of 250%, and if things go south and the value of his investments goes below $2,500, he will be required to top up the additional amount to maintain his margin ratio of 250%.
This means, during market downturns, or when the value of shares that the investor bought drops, Bob would need to stump up more money into the share financing arrangement to maintain the margin ratio, which, in extreme cases, can be a lot.
Should Bob be unable to meet the margin ratio, the brokerage can sell off the position without warning, as well as charge any applicable commissions, fees, and interest.
Nonetheless, the bottom line is that via share financing, investors enjoy better liquidity and better leverage to take up a bigger investment position for potentially higher capital gains, while also conserving cash to be used in other investments that require more cash, like in property.
Suppose Bob has $2 million in free financial resources and wants to buy a house for $1 million. He could put $1 million in the property, and the remainder into a share financing arrangement. If he puts the remaining $1 million into the share financing arrangement, he could have an exposure of $3.5 million, but only having an outlay of $1 million.
To this end, share financing can be suited for both short and long term investments. Some investors would like to put their money into a blue chip stock to reap the dividends, hoping it will cover the interest charged. For more active investors, share financing can also be used for quick forays in and out of the market, so as to capitalise on a quick spike in prices in the markets. Investors can take a position with a share financing arrangement and exit quickly, so as to incur less interest.
