What it is
Macquarie Bank's Zero Cost Collar Facility lets investors protect a shareholding from a drop in price. It sets a share price floor, known as the "protection level", and a "cap" that limits gains from a rise in the share price. This protection does not cost the investor any money. Macquarie or the investor can determine the level at which the protection and cap is set.
Jeff Weeden, Macquarie's equity markets group executive director, says: "Any investor with a large holding in one stock can use the Zero Cost Collar to protect their position against severe market falls, for no cash outlay. They might choose to borrow funds against this position and diversify into other investments."
It has also found favour with employees granted share options, allowing investors to borrow to fund their share purchase.
Investors using a Zero Cost Collar still get dividend income and all franking credits from their share investments.
How it works
Jeremy Nestel, Citigroup's Private Bank managing director, says this type of product is widely available, although not always wrapped up so neatly. It involves using put and call options, which can be purchased from any broker.
"It provides downside protection so you can borrow against your shares," he says. "You can't get that protection from a margin loan."
The investor is buying put options to protect against the share price falling below a certain level and selling call options, which caps gains.
Tony Bates, BTR Financial Services' managing director, says sophisticated investors can buy put and call options at "zero cost" through any broker. But Macquarie's product also offers investors a loan, based on the value of the protected shares. If the funds borrowed are used for investment purposes, the interest may be tax deductible.
What it costs
Bates says Macquarie can earn fees three ways: the cost of the put and call options, and the interest rate charged on the loan, should you borrow against your protected shares. Macquarie's Weeden says this rate is currently 7.67 per cent.
Nestel says: "You come away thinking you've got a good deal on the protection element because you have paid nothing for it. However, you might have paid too much for one side of the transaction and you may not get enough for the other side, because you are selling a call option and buying a put option."
Generally, only fairly sophisticated investors know enough about options to buy their own puts and calls and lock in "zero cost" protection.
The pros
If you have a large shareholding in one company, you can use this product to protect your shares, borrow, then use the funds to diversify, says Bates. But you have to hold at least $100,000 in one company's shares.
"It would work for an executive with a heap of shares in the company he or she works for," Bates says.
It would also be attractive to an executive granted employee options. The option might give the employee the right to buy for $4 a share that is currently trading on the sharemarket at $5. But he or she still has to find that $4 a share to fund the purchase. In the past you would exercise the options, buy the shares and then immediately sell enough shares to fund the purchase. However, this creates an instant capital gains tax (CGT) liability. If the shares are held for a year or more, the rate at which the CGT is applied is halved. Borrowing to fund the share purchase can minimise CGT.
James Foot, Centrestone Wealth Management research analyst, says this product also lets you manage the investment risk in instances where, for tax reasons, exercised employee options are held for a further 12 months. "It provides an effective means of protection against large-scale loss."
The cons
The Zero Cost Collar has a set term of up to five years. If you terminate early, the options must be unwound, which may result in significant costs. If you borrow through Macquarie, the loan is also for a fixed term and early repayment may cost you dearly.
Nestel says the real cost of the product is not transparent because of the nature of options.
Where it fits in the market Bates says anyone with a large single shareholding could find the product useful. It might also suit those whose shares have risen sharply and who want to protect that gain.
Weeden says investors who are cash poor but asset rich can use the Zero Cost Collar to release cash from their shareholding without triggering a CGT liability, and employees granted company options can use it to finance the purchase of shares.
It allows investors to borrow against shares without taking out a margin loan and facing margin calls.
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