Given that leveraging is one of the most controversial strategies in financial planning, you need to practise great care when making leveraged recommendations to your clients.

Case in point: in a recent example of leveraging gone wrong, 756 former clients of Money Concepts (Barrie) of Barrie, Ont., may have lost as much as $40 million collectively by buying investments with borrowed money, according to their lawyers. Retail clients allegedly were encouraged to leverage large amounts, with some individuals borrowing as much as $1 million. The Ontario Superior Court recently approved an amount of $10 million for recovery of combined client losses, as part of a proposed settlement agreement in a class-action suit involving Money Concepts. (See page 8 for more details.)

Other cases of leveraging strategies that may be inappropriate have been attracting the attention of both provincial regulators and the self-regulatory bodies, particularly the Investment Industry Regulatory Organization of Canada (IIROC). And consumer advocacy groups have been sounding the alarm about the dangers of leveraged investing.

Borrowing to invest is not a strategy that is suitable for everyone. It can result in much greater losses than simply investing your client’s available cash. But it can be a valuable tool for informed clients to increase their wealth – as long as you ensure that your clients fully understand and can manage the risks, such as a decline in financial markets, a rise in interest rates or a drop in the client’s income.

What makes leveraging more risky than conventional investing is that both gains and losses are amplified when borrowed money is added to the amount invested. For example, if your client invests $50,000 and borrows another $50,000 to invest, a 30% drop in value of the overall $100,000 nest egg translates into a $30,000 loss, or 60% of the client’s original $50,000 commitment.

The fact that the loss is doubled in such cases, and that clients are dealing with borrowed money, can increase your clients’ anxiety should markets move against them. This anxiety can lead to irrational behaviour by your leveraged clients, who may be more likely to panic and sell at market bottoms, thereby locking in their losses.

If, on the other hand, the leveraged investment rises by 30%, your client will be thanking you for the robust gain of $30,000, or a 60% return on the original cash in hand.

With interest rates likely to rise as the U.S. central bank embarks on its “tapering” program, your leveraged clients also could be hurt by a rise in their borrowing costs, which would raise the minimum return required on their investment. (For the leveraging strategy to work, the anticipated after-tax return must exceed the after-tax borrowing cost.)

Borrowers must have a high enough income that they can carry the loan without relying on any income or gains from the investment, and leveraged clients must be able to handle an increase in loan payments and continue to carry the loan if interest rates rise.

Equities investments make the most sense for a leveraging strategy, as returns are in the form of tax-advantaged dividends and capital gains.

But equities also are the most volatile asset class, and leveraged clients need to be able to stomach the ups and downs. A client in the top tax bracket will reap the most benefits from the tax deductibility of the interest on loans assumed for the purpose of investing.

When borrowing makes sense

Although there are many cautionary tales about financial advisors and their clients who embarked upon a dangerous level of borrowing for the purpose of investing, if it is done conservatively and as part of a long-term financial plan, this strategy can make sense.

Talbot Stevens, an author, speaker and consultant on financial matters in London, Ont., says the clear suitability guidelines established in recent years and greater accountability on the part of advisors have created a safer borrowing environment.

Another factor is the increased accessibility of “no-margin call” loans, for which clients are not forced either to pledge more assets as collateral or pay down their loans if the value of their investments decline.

By contrast, the traditional margin loans offered by many investment dealers require clients to maintain a predetermined asset-to-loan ratio. If the value of the assets declines, your clients could be forced to sell their investments into a bear market in order to comply with the terms of the loan.

“While some [people] consider borrowing to invest a riskier strategy, it is possible to leverage in a conservative, responsible way,” says Stevens, author of The Smart Debt Coach: Secrets of the Rich to Increase Your Wealth and Security. “My definition of ‘conservative leverage’ is to borrow such a small amount that there is no financial or emotional strain.”

Warren Baldwin, regional vice president with T. E. Wealth in Toronto, says there are situations in which it makes sense for a client to reorganize debts, pay down non-deductible debt such as a home mortgage and credit card balances, then arrange a tax-deductible investment loan secured by a conservative, equities-based portfolio.

Baldwin has seen leverage work when it’s handled well. He cites the case of one client who borrowed to invest and paid the loan off within a few years. This client employed a leveraging strategy three times and succeeded in building a large investment portfolio more quickly than he could have without borrowing. The client had a disciplined approach to paying the loan back, and any bonuses or extra income he received were applied to reduce the loan’s balance.

“The client had significant assets and could afford to do it,” Baldwin says. “He was already experienced with leveraging in real estate. And, if the stock market had gone sideways, there would not have been the ‘Oh my God!’ factor. People borrow for all kinds of things, including cars and houses. The advantage of borrowing to invest is that it’s tax-deductible.”

Clay Gillespie, managing director with Rogers Group Financial Advisors Ltd., seldom recommends leverage, and would discourage the practice unless his client had a high level of disposable income, high risk tolerance and experience with borrowing.

“I wouldn’t do it with a client unless I had been through a market downturn with them already,” Gillespie says. “It takes a full market cycle to assess a client’s true risk tolerance. You may ask the hypothetical questions; but until you actually live through a market downturn with a client, you don’t know how he or she will react.”

Ted Rechtshaffen, president and CEO of TriDelta Financial Partners Inc. in Toronto, suggests a time horizon sufficiently long to recover from any market downturns and careful borrowing.

For example, a five-year, fixed-rate loan locks in the interest rate and allows for repayment of principal as well as interest. For a younger client, Rechtshaffen says, a conservative strategy such as increasing the amount of a regular investment by 25% through borrowing can be effective.

“You shouldn’t risk more than you can afford to lose,” Rechtshaffen says. “That’s how leveraging gets a bad name – when clients with very little money are persuaded to borrow large amounts. Leveraging should add value over time, but it has a stigma largely because the wrong people are doing it.”

Best practices

Compliance examinations of securities dealers conducted by IIROC have turned up a number of cases in which clients did not fully understand the costs and risks of leveraging. IIROC has responded with a proposed list of best practices to provide guidance to firms in complying with the existing rules regarding client leverage. The goal is to ensure proper client suitability and borrowing levels, and create a more robust framework for supervising leveraged accounts.

The new guidance regarding borrowing to invest is now in the final stages, after consideration of feedback from financial services industry participants, and is expected to be published this month.

“We felt guidance would be helpful to the industry and investors,” says Rosemary Chan, senior vice president of member compliance and general counsel with IIROC, “as leverage is used in some strategies.”

In some cases, leveraged clients are not being provided with sufficient information to understand properly the risks associated with borrowing to invest. With two severe market crashes since 2000 and long periods of paltry returns in equities markets, many clients have learned the hard way that leveraging magnifies both losses and gains. Chan says that although rules are in place regarding leverage, IIROC will be clarifying its expectations regarding how dealers can comply more effectively.

Chan stresses that leveraging strategies are attractive to some individuals and “totally appropriate in some cases. The new guidelines contain much more detail about best practices, and go further than simply reminding dealers of their obligations.”

For example, margin loans arranged through IIROC member firms are easily visible to firm supervisors; however, when loans or home-equity lines of credit are advanced by third parties, such as banks, these loans are considered to be “off book” and are more difficult to monitor.

IIROC is pushing for firms to have adequate systems to flag off-book leveraging. Among these red flags are large investments or transfers into client accounts, as well as communications from lending institutions regarding the value of the client’s portfolio.

The ultimate message is you need to be asking more questions about where your clients’ money is coming from.

Dissenting voices

Several responses to IIROC’s draft proposals questioned whether tracking all of a client’s personal borrowings could be too onerous, impractical and costly to implement. Advocis president and CEO Greg Pollock, for one, says it is “excessive” to expect a dealer to monitor account activity constantly in order to ascertain whether a client has engaged in borrowing but hasn’t disclosed it.

“How far should the dealer be expected to go to investigate possible off-book leverage?” Pollock wrote in his response to IIROC’s proposals. “Does guidance of this nature potentially open the dealer and the representative to liability for failing to find out about and take into consideration off-book leverage that the client did not disclose?”

The Canadian Foundation for Advancement of Investor Rights (a.k.a. FAIR Canada) is urging regulators to increase investor protection. Ermanno Pascutto, executive director of FAIR Canada, says a “systemic incentive” is in place that encourages advisors to recommend leverage, even in situations in which it is not suitable, because a larger asset base generates higher commission income and trailer fees for the advisor. Pascutto calls this situation a “misalignment of the interests” of the financial intermediary and the consumer.

Among other recommendations, FAIR Canada has urged regulators to “institute a presumption that leverage is unsuitable for retail investors,” which would place the onus on the advisor and the firm to prove that borrowing is suitable for the client.

Pascutto stresses that he is not worried about clients who borrow small, manageable amounts of money, such as a loan to make an RRSP contribution. But he is concerned about loans worth hundreds of thousands of dollars made by clients who are encouraged by low interest rates and the current easy lending environment.

The emotional acid test

When it comes to assessing the appropriateness of a leveraging strategy for any client, says Talbot Stevens, a finance-related speaker and author in London, Ont., it’s important to go beyond the financial criteria and consider the more subjective emotional aspects of your client’s personality.

Client behaviour in volatile markets can be one of the biggest determinants of investment success. And leveraging magnifies not only the gains and losses, but the emotional highs and lows that can accompany them. Intense emotional states often lead to poorly considered moves, such as buying high and selling low.

Stevens has devised the following questionnaire for clients considering leveraged investing. He calls it “the emotional acid test”:

If my leveraged investments drop by 30% in value three weeks from now, I will:

A: want to buy more, because investments now are “on sale”;

B: have faith and hold, committed to the long-term plan;

C: hold somewhat nervously, questioning why I leveraged;

D: want to sell, unable to sleep at night;

E: insist on selling, stressed and upset with my advisor;

F: shoot (or sue) my advisor, who introduced leverage.

If the answer is D, E or, especially, F, your client should wait until he or she is more emotionally ready for leveraging. If the answer is C, Stevens says, your client may want to reconsider, wait or start with a smaller amount until he or she gains more confidence and understanding of the process.

The major risk of leveraged investing is emotion-related. When investors leverage aggressively, Stevens says, they tend to get scared and sell when times get tough.

Even if all the financial risks are understood, he adds, the emotional risks can result in leverage doing more harm than good.

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