Thursday, 26 July 2007

HyperGearing Case Study

Most of us would have a mix of asset in our investment portfolio - ranging from the low-risk, low-return government guaranteed bank account, through stock and real estate investments, and up, up and away into the stratosphere of geared, high-risk, high-return investments. Rather than invest in just one asset class of investment product that matches my risk-tolerance and desired return I have a mix of different investments, accumulated over time via deliberate diversification strategies and a large dose of "it seemed like a good idea at the time" strategy. In this post I'll look at what is probably my highest-risk investment, track how it's performed so far, and establish a baseline for keeping an eye on it's long-term performance over the coming years.

Investment: Hedge Fund (Macquarie Equinox Select Opportunities Fund), 100% geared using funding from a Macquarie Structured Products Investment Loan and annual interest payments capitalised using a line-of-credit loan against my property portfolio equity.

Principal Loan: $50,000 borrowed for the initial investment @7.75%pa fixed, paid annually in advance each June ($3,875 pa interest)

Interest Capitalisation Loan: The $3,875 pa interest payment on the principal loan amount is borrowed each June using my home equity line of credit, @ current variable home loan interest rate -0.7% "professional package" discount +0.1% "portfolio loan" premium. Currently the interest rate is 7.33% pa. This interest is paid monthly from my credit union savings account. (I could have also capitalised this interest on interest, but I couldn't be bothered as the amount each month is quite small, and I'd be pushing my luck regarding the tax-deductibility of such interest payments).

Investment Performance:
14.46% in the first year

Tax Considerations:
In order to ensure that the interest on any loan used to purchase the investment is tax deductible, the Macquarie Equinox fund is designed to pay a small "dividend" each year - estimated in the PDS to be around 1% pa. The dividend for the year ended 30 June 2007 will be declared by the end of August. For the evaluation of the tax effects of this investment I've assumed a 1% dividend is declared.

Taxable income from investment: 1% x $50,000 = $500

Deduction for interest paid on investment loan:
7.75% x $50,000 = $3,875

Deduction for interest paid on capitalised interest:
7.33% x $3,875 = $284

Net effect on taxable income:
$500 - $3,875 - $284 = $3,659 reduction

Marginal income tax rate = 30%
Reduction in income tax payable for 2006/7 FY: 30% x $3,659 = $1,097.70

Unrealised Capital Gains for 2006/7: 14.46% x $50,000 = $7,230
Capital Gains tax rate = 50% x marginal income tax rate = 15%
Unrealised CGT due when investment is liquidated: 15% x $7,230 = $1,084.50
Net Unrealised Capital Gain: $7,230 - $1,084.50 = $6,145.50

Net after-tax profit calculation:
= Investment Value - Loan balance - interest paid + tax refunds - CG tax due
= $57,230 - $53,875 - $284 + $1,097.70 - $1,084.50
= $3,084.20

It's a bit hard to work out a ROI as I used OPM to fund this investment, but as a ball-park figure I assume that I "used" $3,875 of home equity that could have otherwise been invested elsewhere, plus I paid out $284 in interest on this home equity loan. So, ROI becomes $3,084.20/($3,875+$284) = 74.16%

On the face of it this looks like a great little money-maker, BUT the potential riskis huge. Worst-case the investment could become worthless, leaving me with a $53,875 in debt to repay. So, as nice as a 74.16% pa return is, I'll restrict my total investment in this high-risk asset class to the current $50,000 - which is around 4.3% of my net worth. This limits the potential maximum loss to around $88,750 after ten years, vs. a "likely" net profit of around $90,980 after ten years (assuming interest rates stay the same, tax rates stay the same, and the investment return averages 14.5% pa).

Break even requires an averaged investment return of 5.98% pa (It's less than the cost of borrowing to invest due to the tax effectiveness of the investment).

Best-case scenario would be a net profit of $191,674 if the investment return averaged 20% (a figure quoted in the PDS as a "projection" based on historical returns for the underlying investments used to value to investment). This best-case scenario is highly unlikely, with the "historic" return data for many of the underlying investments being only a couple of years!

Doing a back-of-the-envelop estimate of "probable" outcome, I get the following:

Outcome Probability Scenario
-$88,750 10% Stay invested for 10 years, then investment goes bust
-$ 6,930 20% Stay invested for 10 years, investment return avg 5%
$16,264 25% Stay invested for 10 years, investment return avg 8%
$90,980 25% Stay invested for 10 years, investment return avg 14.5%
$131,567 19% Stay invested for 10 years, investment return avg 17%
$191,674 1% Stay invested for 10 years, investment return avg 20%

The Weighted average outcome is a profit of $43,464. (As a reality check this equates to an average return of 10.77%, which seems realistic)

Overall, I estimate that the likelihood of losing my entire 4.3% of net worth that I've put into this high-risk is only around 10%, and that there's a reasonable chance that this investment could increase my net worth by an extra $100K to $200K in ten years time.

This is a good illustration of how slack my investment due-diligence and risk analysis really is. Checking through the PDS again I found that:
a) The 10-year historic return of the underlying investments is actually around 15%, not 20%
b) This investment is supposedly "capital guaranteed" - so worst-case I *should* get back the initial $50,000 at the maturity date
c) There is a "rising guarantee" that "locks in" a part of the increased fund value each year (if any) - this may mean that by the end of August the rising guarantee has increased to maybe $53,000 - which would then become my "worst-case" scenario
d) The investment matures after 8 years, not 10. But at that time the fund "rolls over" into an investment in the top-10 ASX listed stocks, so it won't trigger a CGT event at that time. I may need to refinance to $50,000 loan at that time though.
e) I really don't understand exactly what mix of underlying investments the fund performance is linked to and I don't know what fees are being siphoned off - probably a lot, as exotic investments tend to have high management fees, and capital protected products tend to be loaded up with hidden costs.

So I've violated the cardinal rule to "only invest in things you understand". Then again, although $50,000 is a sizeable investment in one product, it's only 4.3% of my total net worth, and an even smaller % of my total investment portfolio. And some of the benefits (income tax deductions, investment asset diversification into non-correlated asset classes) are pretty certain.

If I was a more risk-averse investor I'd not invest in this product in the first place - instead I'd make a "risk free" 7.33% after-tax ROI by not drawing down my home equity loan to pay the interest on this investment.

On the other hand, a more risk-seeking investor might add $50K or $100K of such an investment to their portfolio each year, using every bit of available equity to fund the investment borrowings. If things worked out, after ten years you could have made an extra $1m or so and be able to retire, or possibly write a book and teach seminars on how to make a fortune through speculative investing ;)

Copyright Enough Wealth 2007

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