By Peter Temple | Wed, 3rd August 2011 — 23:00

CFDs (contracts for difference) have become an increasingly popular way for well-heeled investors to play the market. But they have idiosyncrasies that lie in wait for the unwary. One of these is the way that interest and dividends are treated.

This is a particular feature of CFDs that is not, for example, present in spread betting.

The simplest way of looking at a CFD is to think of it as a way of buying shares using a short-term loan.

You stump up your initial deposit, you get a loan to buy the shares, and you pay interest on the loan a daily basis.

When you sell, you use the proceeds to pay off the loan and pocket (or pay) the difference. Because you are borrowing most of the cost of the shares, your return — if the shares go up — is magnified. Of course if they go down, your percentage loss is magnified as well.

The strict definition of a CFD is that it is a total return equity swap, designed to replicate the economic performance and cash flows of a conventional share investment.

Leaving aside the fact that, in contrast to spread betting and futures and options trading, CFDs have no expiry date, the main difference between CFDs and other highly geared trading instruments is that the cost of the financing inherent in the contract is separate from the price, rather than being included in it.

In a CFD, the price you pay is at — or very close to — the price in the normal stockmarket, but the interest on the margin loan is debited or credited to your account on a daily basis depending on whether you are going long or short. Interest is calculated on the terms specified by your CFD provider. It will, however, normally debited at a premium to the overnight rate and credited at a discount to the overnight rate.

Owning the CFD

Although you don’t technically own the underlying shares, the contract (and the outside world) assumes you do. If you are long and the share goes ex-dividend during the time your CFD is open, your account is credited with the net dividend. By the same token if you are short and the same thing happens, your account is debited with the gross dividend.

This contrasts with spread betting and futures, where there is no right to any dividends on the shares that might be the subject of a bet or a futures trade, although ex-dividend effects tend to be built into futures prices automatically by the market.

It’s also worth remembering that most CFD brokers charge commission based on the underlying consideration on the shares, rather than the deposit that you stump up at the outset.

In other words, not only are you paying interest on the margin loan, the chances are you are effectively paying commission on it as well. Those brokers that advertise themselves as offering commission-free dealing on CFDs are not being charitable; they are simply recouping their commission in some other way, perhaps by charging a higher rate of interest on the margin loan.

How significant you regard the fact that interest and dividends are charged and credited to a CFD account — based on whether you are long or short — depends on the size of your investment. But here’s a ready reckoner. If you take out a £10,000 ‘long’ CFD on the basis of a 20% deposit (that’s an £8,000 margin loan), and interest is charged at 5.5%, in rough terms you will be paying around £1.20 a day in interest.

Throughout my investing career I have steered well clear of CFDs. I find it easy enough to lose money in the stockmarket without gearing up my bets and losing even more.

Those more attuned to short-term trading may find them a useful tool, and they’re a way of achieving economic exposure to a more diverse range of companies with limited capital — but this objective can be achieved at extremely low cost by buying an index tracking exchange traded fund.