Negative gearing plays a big role in allowing investors to build a portfolio of properties. It’s similar with the share market where you can use borrowed funds to build a portfolio of shares. It’s a strategy well established in the United States and Europe, but still relatively embryonic in Australia.

Investors have several options at their disposal to enact a strategy, including margin loans, secured loans and protected equity loans (PEL) – it’s the latter we will focus on in this article.

How it works

Put simply, a PEL allows you to borrow up to 100% of the cost of buying shares and at the end of the loan term you hand over any loss-making shares to the lender and keep any profits from stocks that have performed.

For the investor, a PEL removes risk from share market falls, and the only thing you need to cover over the term of the loan is the cost of the protection embedded in the product and interest payments, which are paid upfront on an annual basis. You even get dividends and franking credits from the shares purchased, providing an income stream in addition to tax advantages to help offset your interest payments.

This is made possible using investment tools like put options in the loan terms. These are used to insure any downside in your portfolio, and act as protection for the lender. As the lender is taking on risk in the transaction you can expect the costs will be higher compared to other products like margin lending, where the risk is more centred on the borrower.

There may be other options that allow you to set the percentage gain you can make from each stock selected – with anything over that cap going to the lender – in return for a reduced cost of protection.

The tax advantage

PEL’s also have potential tax advantages, particularly around interest deductibility. It will depend on your personal circumstances but if you’re borrowing money to buy shares for the purpose of generating assessable income, in the form of dividends, you can generally claim a tax deduction for interest charged on the borrowed money. And if you prepay your interest, you may be able to claim an immediate deduction for it under the “12-month rule” for prepaid expenditure.

To give an idea how it works, let’s say you purchase five stocks at $50,000 each. At the end of the term three stocks have risen in value and two have fallen. You receive the gains made by the stocks that have increased but carry none of the burden from the stocks that have fallen. If you had $250,000 to invest you could have held the portfolio outright, but you would have had to deduct the losses from those two stocks into your total return.

Equity secured lending is a fast growing area of activity in Australia, but still well shy of the use made in other developed markets. In Australia it only accounts for 1-2 per cent of the total market capitalisation of the ASX, compared to between 5-25% of equivalent bourses in the US and Europe, according to Reserve Bank of Australia data.

Extended periods of market turbulence, which we have experienced with increasing regularity for over a decade, are drivers of uptake in strategies that offer protection to the investor.

PEL Benefits

• Borrow up to 100% to purchase a share portfolio of approved stocks.
• Protection from downside movements in the share market.
• You only need to cover your interest payments and option premiums. There are no margin calls or other potential demands for additional funds.
• No need to offset losses against gains. You receive the proceeds from gains and your lender retains any stocks trading at a loss, assuming you borrowed 100% of the funds to build the portfolio. If you only borrowed 90% you will carry a 10% downside risk against any losses.
• Potential tax benefits.

PEL Risks

• Stock selection and the direction of share markets will determine the performance of your investment.
• You can lose money if the appreciation in your portfolio does not exceed the cost of the financial product
• There may be costs involved if you require an early termination of the contract, including loss of the embedded capital protection.
• All loans are subject to market risk. Certain market events or corporate actions may lead to an early termination of your PEL contract

Conclusion

Overall, PEL’s can be a useful strategy for investors who want to reduce their tax bill and potentially make a profit in the long run. It’s important to remember all investments come with some level of risk, so it’s always a good idea to do your research and seek professional advice before making any financial decisions.

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