InvestmentAAM Business times Steep market declines

Steep market declines can leave leveraged investors exposed

Shreemati Varadarajan is the Chief Investment Officer at AAM Advisory, part of Utmost international.

They say that change doesn’t happen overnight, but anyone following the financial markets recently will beg to differ. It has been a turbulent time for investors, with markets across the world experiencing record-breaking movements as extreme uncertainty in the economic outlook acts as a drag on growth and market sentiment. Despite markets recovering some of their losses after unprecedented central bank intervention, it is clear that the music has stopped, and the 11-year bull market has come to an end.

The freefall has left most investors wincing; struggling to come to terms with double digit falls in markets across the world. But those who have made investment decisions that adhere to their risk profile, with a suitable time horizon, should take comfort in the knowledge that short-term market falls should be smoothed by long-term returns. Any bump in the road can be managed by simply leaving your investment portfolio alone.

For some leveraged investors, however, this current period will not be quite so comfortable, and they will be hurting more than most after the sudden market reversal. Leveraged investors have borrowed against the value of their securities in order to increase their exposure, with the intention of amplifying gains. Risk and reward are two sides of the same coin, however, and once the music stops playing, some of these investors can find themselves in big trouble. Enter the margin call.

A margin call materialises when the value of the investments purchased with the money borrowed falls below an amount required by the lender, known as the maintenance margin. The lender will then demand that the investor deposits more money into the account or sell some of the assets to reduce the margin on the loan. If the margin call is left unmet, the lender has the right to close any open positions to bring the account up to the minimum value, without having to get prior permission from the investor. If this happens, losses can be super-charged and will crystallise immediately.

In the private client space, leveraged investing can work well in a bull market to take advantage of rising values and it can be a useful tool available for wealth managers to build client’s wealth. As such, two products have been particularly popular in Singapore before the current crisis as investors searched for yield in a low interest rate environment.

Share-financing, which is a loan facility provided by a bank secured against the value of the equities, allows investors to leverage their position in financial markets. Similarly, leveraged fixed-coupon notes, which are structured products tied to an index of securities, take a leveraged position to provide investors with a regular coupon.

However, to avoid the trap of the margin call, wealth managers must ensure that their clients are not over-leveraged, and they must consider the client’s overall financial situation, assets and liabilities before offering leverage. Wealth managers must also monitor their client’s positions carefully and should advise clients to close a leveraged position before a margin call takes place. That said, it is very difficult to do this due to the inability to time the market and nobody could see this pandemic on the horizon. Clients need to bear this in mind before entering into any leverage arrangements.

Like any good advice, clients must be presented with, and fully understand both pros and cons of leverage before signing on the dotted line. They must know exactly how much they are paying for the leveraged positions and whether the gains outweigh the cost on an ongoing basis. An authorised and experienced wealth manager will have the technical knowledge and experience required to ensure that you meet your financial goals and will give you great comfort, especially in these turbulent times, knowing that you will weather this storm and will not be forced into crystallising losses by meeting a margin call

We don’t know when the recovery will happen, but we do know that there will be a recovery and most investors will recoup either some, most or all of the losses sustained in the past month. While leveraged investments are a useful tool in investment management, and can help some increase their gains, they should only be used by someone who truly understands what they are entering into as there is always the potential to maximise losses by leaving investors exposed to a margin call. Plan wisely and be discerning when you select your wealth manager.

This article first appeared in The Business Times, Monday 20th April 2020

 

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