The 15-minute videotape features upbeat music, detailed charts, a luxurious office— and confident executives extolling the rewards that can be had by borrowing money to invest in mutual funds. Distributed by Vancouver-based First City Trust Co. to help mutual fund salesmen sign up new clients, the sleek presentation conjures up an investor’s dream: a man with $10,000 borrows another $20,000 and buys shares in mutual funds—a portfolio of stocks and other securities run by professional money managers. In eight years the investor’s net worth jumps to $114,000. The tape underlines how easy it is—loans for up to 66 per cent of the amount that a client wants to invest in a mutual fund are “readily available” from First City. What is more, notes the narrator, “it’s all handled by your mutual fund adviser. You never even have to go into a First City office.”
In the booming mutual fund market, such a hard sell is really not needed. Encouraged by the stellar performance of most mutual funds—as well as the easy financing available from some trust companies and banks—small investors have rushed to buy in unprece-
dented numbers. According to the Toronto-based mutual fund industry association, the Investment Funds Institute of Canada (IFIC), investors poured more than $2.9 billion into 196 Canadian-based mutual funds in the first six months of 1986—compared to $792.7 million invested in the same period last year. But industry and regulatory officials say that they are increasingly worried that more and more novice investors are borrowing money to invest in mutual funds—or “leveraging,” in financial jargonjust as the four-yearlong bull market has begun to show signs of turning bearish. “Our best guess,” said IFIC president Keith Douglas, “is that about 30 per cent of equity [stock] fund purchases in the past year have borrowed money involved.” The use of leveraging, Douglas added, has never before been so high.
Last week, in an effort to warn investors who may not be aware of the
dangers of leveraging, the IFIC and the Ontario Securities Commission (OSC) staged a press conference in Toronto to announce new guidelines aimed at protecting investors. Starting on Sept. 1, most mutual fund salesmen will be required to give clients who are considering leveraged investments a two-page OSC disclosure document pointing out that “a leveraged purchase of mutual funds involves greater risk than a purchase using your cash resources only.” That requirement will apply to the estimated 75 per cent of fund salesmen who are neither stock &l; brokers nor employees ü of financial institutions, o As well, the IFIC an= nounced that it would ¿ urge its members to use restraint in recommending leveraged investments.
Leveraging has long been used by sophisticated investors to increase the potential profit of an investment. If an investor buys $20,000 worth of stock-
half of it with borrowed money—and the value of the stock rises to $25,000, the gain is 25 per cent. But his personal $10,000 stake is now worth $15,000— a 50-per-cent gain. By borrowing he has doubled the gain on his own money. There is also a tax benefit, because interest payments on money borrowed for investment purposes is deductable.
But what most people do not understand, the IFIC’S Douglas explains, is that leveraging doubles losses in the same way that it doubles gains. If the same $20,000 worth of stock declines in value to $15,000, the investor—who still must repay the $10,000 loan—sees his own equity fall to $5,000. The typical small investor, said Toronto stockbroker David Wilkes, often does not “understand the consequence of leverage when the market goes the wrong way; he sells out, and in effect he has destroyed his entire equity because of leverage.”
There are other pitfalls. If the market turns down —reducing the value of mutual fund holdings —financial institutions are often quick to demand repayment of part or all of the loan. And because the lender holds the mutual fund units as collateral, he may sell them at depressed prices in order to recover the loan. Pointing to the stock market downturn of 1982, Robert Stewart, chairman of the IFIC and president of Toronto’s Dynamic Funds Management Ltd., said that “the first loans that are called are security loans.”
Officials with the OSC and the IFIC also said that they were concerned about the aggressive lending policies of four financial institutions—the Bank of Montreal, the Continental Bank of Canada, First City Trust and Canada Trust Co.—which have set up special programs designed to streamline loans to borrowers who want to invest in mutual funds. Canada Trust will lend up to 75 per cent of the amount needed to buy into a mutual fund, while the Bank of Montreal will lend 100 per cent. One of those institutions, which the IFIC’S Douglas declined to name, offers leverage on top of leverage. If an investor’s mutual fund units rise in value, he can borrow more on the basis of the new worth. Said Douglas: “That is even more risky.”
Another worrisome practice is that the borrower sometimes does not even visit the trust company or bank. Instead, the mutual fund salesman fills out the loan application and sends it on to the financial institution. The danger, according to regulators, is that mutual fund salesmen—who earn commissions based on the size of the investment—may not warn of the risks involved in leveraging or may urge investors to borrow more than they can really afford. The mutual fund salesman, said Harry Malcolmson, the OSC’s associate director, must ensure that the leveraging component of an investment is suitable.
The growing concern over the push to leveraging is shared by some stockbrokers and fund salesmen themselves. Said Earla Burke, president of Moneystrat Inc., a Toronto investment firm that also sells mutual funds: “Some brokers get too greedy about just placing orders. A lot of people get sucked into this get-rich-quick scheme.” Added Calgary stockbroker Emmett Donovan: “There are some people out there who are really flying high. I think we have some fast-buck operators getting involved.”
Still, industry experts insist that for investors who are aware of the risks, leveraging makes good financial sense. Peter Horlock, for one, a 60-year-old Toronto industrial engineer, decided to invest in mutual funds as a way of building up his retirement savings. After investing $30,000 of his own money and earning a $9,000 profit in a two-
year period, Horlock decided last year to borrow another $20,000 to put into mutual funds. The entire amount of the loan was provided by the Continental Bank of Canada. But Horlock, who said that he can repay the $20,000 if necessary, says he is concerned that less affluent borrowers may be persuaded to make loans they cannot cover. Declared Horlock: “There needs to be some control.”
Financial institutions that have begun to specialize in loans for mutual fund investment defend the practice, arguing that strict borrowing requirements protect investors against illjudged investments. For one thing, all borrowers must still pass credit checks. Said the Bank of Montreal’s Alan Taylor, senior vicepresident and senior consumer credit officer in the domestic banking division: “The bank is trying to service its customers.”
Doris Bradstreet, First City’s vice-president in charge of marketing, said that borrowers must be able to repay loans from sources other than their mutual fund holdings. Bradstreet also defended First City’s use of a videotape to promote leveraging. Consumer loans and car „ loans are also presented < to customers in a very 9 positive manner, she said. And it is not necess sary, Bradstreet added, z for a loan applicant to 1 visit a First City office because “we do not have to see a person to understand his credit worthiness.”
For its part, the OSC, which has not ruled out imposing margin requirements on mutual fund investments if its efforts at persuasion fail, will urge the Canadian Bankers Association and provincial government authorities to encourage more restrained lending policies. OSC officials admitted that despite minor stock market declines over the past several weeks, the commission has yet to receive any serious complaints from mutual investors. But, said John Leybourne, the commission’s deputy director for enforcement, “I am sure that if there is a major market correction we will have some complaints.” Added the IFIC’S Stewart: “It’s the small guy we’re worried about.”
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