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Leverage-What is it and is it right for you?

Tuesday, November 17, 2009

When I was hired at Investors Group in 1996, all the new advisors went through an in-house training program. We spent much time analyzing how we were going to build a book of clients from scratch, as most companies don’t give new advisors a handful of clients to start out with. Most of the remaining time was centred on mastering a handful of concepts to help grow your business.One of these concepts was leveraging. At almost every company meeting, this concept was taught by managers or successful advisors in the firm who utilized it. Examples were put up that showed if a client had $300 month to invest and they invested in the traditional method (RRSP or non-registered), the advisor would earn approximately $140 a year in commissions.If, on the other hand, the client borrowed $50,000 and used the $300 to pay the loan, the advisor could now earn approximately $2000 in commission from the $50,000,plus get paid higher ongoing management fees from managing more client assets. One advisor I knew sold a leverage, the market corrected, and the clients redeemed. They were down $20,000 and still paying for the full amount of the loan, plus had to pay management fees to redeem as they were sold on a DSC(deferred sales charge)basis. The advisor said to me” I don’t care; I’ve already been paid for it”. Investors Group even brought in Talbot Stevens to conduct seminars to help explain his “conservative leverage” plan. I’ve seen many cases of leverage gone wrong during my career in financial services. Leverages sold to seniors who had incomes of $30,000 a year. Leverages sold to clients who shouldn’t have qualified on an income or job basis. I’ll attempt to explain how leverage works and when it may be right or wrong (everybody’s personal circumstances/risk tolerance vary).


Leveraging refers to the method of using borrowed money or a combination of cash and borrowed funds to finance securities (stocks/mutual funds among others).The main benefits to the investor are; a) they have a larger sum working in the markets;b)interest on the loan becomes a tax deduction, helping to save income tax. As long as the investment is used for income –producing purposes. Keep this loan separate from any other loans to calculate the interest portion accurately and be able to satisfy Canada Revenue Agency, if necessary.
Leveraging can magnify gains or losses. If the stocks markets are trending up, you have this much larger sum experiencing the growth. If $100,000 of mutual fund units are bought with $25,000 from available cash and $75,000 from borrowings, and the value declines by 10% to $90, 000, your equity interest (the difference between the value of the securities and the amount borrowed) has declined by 40%, i.e.from $25,000 to $15,000.The 10% decline in this example is relatively minor compared to a few of the major market corrections we’ve experienced in the past decade. A major correction might mean you need to hold onto your leverage for 5-7 years just to break even, and that’s not counting your ongoing interest payments (that are tax deductible) that continue regardless of how your investment is doing.

Potential Candidates for this Strategy:

a) Currently maximizing RRSP contributions. It simply doesn’t make sense to consider higher risk strategies when you haven’t utilized the basics first.
b) High Income. Generally speaking, clients should have incomes in excess of $70,000 to take full advantage of the tax deductions plus have sufficient cash to fund the leverage in addition to everyday cash needs.
c) Small mortgage or better yet, no mortgage. This is always an advantage because again it is a simple concept that can help you become financially independent, plus it reduces your ongoing cash outflow.
d) Secure job/career. The last thing you want eating up your cash flow upon job loss is an investment loan or worse yet, be forced to sell if markets are down. Government workers, teachers, nurses, doctors, dentists and other professions who work in relatively recession proof fields are best suited to the idea of leverage.
e) Able to handle market volatility. This concept is a long term (minimum 5 years) strategy and candidates can’t panic if markets decline. You have to believe that stock markets are positive indicators. As illustrated at the top of this article, leverage magnifies losses and panicking will only make a bad situation worse.

My Concerns:

I rarely even present leverage to my clients because the potential problems are usually greater than the potential gains. Job loss, market corrections, disability, divorce, and many other unforeseen life events make this strategy risky, which is why investment companies have you sign off on extra documentation to ensure clients understand what they are getting into. Advisors who sell this concept frequently use charts and graphs showing a 6-8% yearly return (sound good?) and this makes the concept seem foolproof. They never include a 40% correction in the graphs like we experienced last year. They usually show steady growth, which isn’t how stock markets work.
If you decide to go ahead with leveraging based on your situation, make sure you buy 0% FE load mutual funds. If you ever have to dissolve the plan, having to pay DSC charges makes it more painful and less profitable.
Don’t buy when stock markets are near or approaching record highs as that is a recipe for disaster. The problem is that for most investors buying low is very difficult, so selling this concept works better in up markets as the number look better and investors are in a positive frame of mind.
I hope that this helps you to go ahead with leverage if it’s the correct strategy for you and not because it’s in the best interests of your financial advisor who is “selling” you based on unrealistic numbers. I also hope you firmly say NO if it’s not in your best long term interest, or if based on some of my parameters, this just isn’t right for you.



Generic Mutual Fund Disclaimer

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the simplified prospectus before investing. Mutual funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that the fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently and past performance may not be repeated.

Personal Opinions & Recommendations Disclaimer

The foregoing is for general information purposes only and is the opinion of the writer. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice. However, please call the author to discuss your particular circumstances.