The value of one-click gearing

Financial Review

Mark Story

Updated Jul 7, 2015 – 12.59pm,first published at 12.30pm

Gearing as part of a strategy to accelerate wealth accumulation is universally understood. It's only ever suitable for investors with an appetite for risk because it magnifies both your profits and losses. But the inner workings of an internally geared share fund or ETF are not as widely acknowledged, much less understood.

Their "administrative ease" compared with other forms of borrowing, such as margin loans, means internally geared share funds have found favour with investors on their own merits, especially those comfortable with outsourcing their investment decisions and certain members of self-managed super funds (SMSFs).

Sometimes referred to as "a one-click gearing strategy", internally geared share funds offer a no-fuss alternative way to leverage into shares. These funds simply manage the geared exposure for you, without the lingering threat of margin calls that come with borrowing from a bank or broker. But the one-size-fits-all nature of these products also implies certain limitations which may prove to be a deal-breaker for many.

Sometimes referred to as "a one-click gearing strategy", internally geared share funds offer a no-fuss alternative way to leverage into shares. Louie Douvis

Pitched as an easier way to pursue a geared investment strategy, a number of specialist internally geared share funds have a structure within which internal borrowings average about 25 per cent to 50 per cent of the total fund. This is then used by the manager as an extra source of finance to acquire more investments on your behalf.

Niche area

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One of the pioneering funds in this space is the Colonial First State Geared Australian fund, and since the early 2000s another 30-plus similarly geared share funds have joined the party, charging an average of 1.7 per cent in fees. Perhaps surprisingly, there is less than $5 billion invested across these strategies overall. This is not a problem of accessibility either, with most funds accepting minimum investments of between $1000 and $5000. Indeed, more than half the funds in operation have less than $10 million under management.

In a new spin on this theme, ETF provider BetaShares has a geared Australian shares ETF that offers a broad exposure to Australian equities. But while most internally geared funds are actively managed, this product simply provides exposure to the broader market at lower costs.

Internally geared share funds typically borrow on behalf of investors at wholesale interest rates, which can be significantly lower than what you could access yourself.

The workings

All things being equal, an internally geared share fund has the potential to significantly outperform (or underperform) its ungeared counterpart, and the higher the gearing, the more volatility you'd expect to see in the unit price.

How an internally geared share fund works in practice is relatively simple.

Let's assume you invest $50,000 in an internally geared share fund via a unit trust, which borrows at a wholesale interest rate of (for illustrative purposes only) 6 per cent annually, to which the geared share fund adds another $15,000 of borrowed money.

Your total investment is now $65,000, with a very modest gearing ratio of 23 per cent (that is, $15,000 / $65,000 x 100). In other words, for every $1 invested in the fund, you now have $1.30 worth of exposure.

While investors will be attracted to one or the other based around perceived convenience, personal tax circumstances and risk tolerance, the returns of shares geared with a margin loan behave exactly the same as those of a geared share fund – with one exception.

Unlike margin loans, an internally geared share fund is generally "limited recourse", which means that if the investments fall in value below the level of fund borrowings, you're not required to pay back the shortfall to the lending institution.

The most you can lose with these investments is your initial capital outlay, and this could save you from losing your shirt if things go totally pear-shaped.

The other beauty of limited recourse borrowing is that SMSF members can use internally geared share funds to sidestep onerous asset restrictions.

No immediate tax deductions

Despite the many attractive features on offer from these products – less paperwork, no credit checks, lower costs – internally geared products have one very significant drawback. They can be far less tax effective.

For example, investors in an internally geared share fund will be unable to pay the interest upfront and claim it against their marginal tax rate like a margin loan. For investors attracted to the tax benefits, this can be a deal-breaker.

Despite this, Jason Coggins, head of managed fund research at Koda Capital, reminds investors that the underlying investment thesis remains the same.

"Irrespective of implementation, gearing is gearing. Gains and losses are both magnified," Coggins says.

"While internally geared funds may not give you an immediate tax deduction, this will be irrelevant when the market experiences a normal sell-off and geared strategies produce losses potentially exceeding 50 per cent."

For a geared strategy to be worthwhile, he says, the ungeared (or market) return must be enough to cover the interest cost, plus any management costs and fees, which are charged on the total amount, including equity and borrowing within the fund.

The interest costs for geared share funds is in the order of cash plus 1.50 to 2 per cent, or slightly less than the net dividend yield from the ASX 200.

As a point of interest, geared share funds typically access low-cost borrowings through short-term loans from other in-house cash‑enhanced and credit strategies.

Less flexibility

Given there's only one gearing ratio for everyone who buys into fund, Brian Phelps, CommSec's general manager for distribution, reminds investors that an internally geared share fund is also considerably less flexible than a margin loan.

Typically, margin loans from a bank or broker are set at a 60/40 or a 70/30 ratio. However, they can be geared up to about 90 per cent, depending on the quality of the underlying assets within your portfolio.

"With a margin loan, investors can not only choose the gearing level but also the asset mix, and either buy direct shares or buy into an ETF, while also having the opportunity to rebalance when it suits," Phelps says.

The other added benefit margin loans have over internally geared share funds, he adds, is the opportunity to pay interests costs before the end of the financial year. Many look to the overall direction of rates before making a decision.

With 40 per cent of its online clients choosing to do so – up from 20 per cent when CommSec first opened for business – pre-paying tax clearly has merit.

"Investors may choose to fix half the loan balance, leaving the variable balance to follow the interest rates down," Phelps says. "The other real benefit of a margin loan over a geared share fund is the greater access to investment classes, access to dividends and franking credits, and the ability to pre-pay the interest on the loan and enjoy the benefits of negative gearing."

Timing is everything

Putting the pros and cons of internally geared funds to one side, Coggins warns investors that the bigger issue will always be around getting the timing right. Take, for instance, the wild ride experienced by Colonial First State Geared Global Property Securities Fund, which launched in April 2007 at $1, only to lose almost 97 per cent of its value less than two years later in March 2009.

While recent history shows the power of gearing in rising markets, it also shows the drag within relatively flat ones in which gearing tends to deliver a negative return, Coggins says. "With fees and interest costs accruing, losses are likely. Investors also need to consider the alpha bets taken by active managers like Colonial. If these are wrong – and they're picking stocks that underperform the market – gearing will compound these losses," he advises.

Every picture tells a story, and the performance of three of the largest and most long-standing internally geared share funds during 2010 and 2011reveals the impact of compounding losses when their bets go the wrong way.

Interestingly, managers with 2005 to 2015 returns close to or below the S&P/ASX 300 Index only highlight the risks of taking (potentially) double the volatility for very little reward. "Gearing has the potential to crystallise permanent losses of capital," Coggins warns. "Given how detrimental this can be, you need to question whether all the angst and effort is worth the potential gain."

While Phelps notes that most of CommSec's clients using margin loans hold their positions for more than 12 months, Coggins says gearing must be opportunistic given it can decimate one's wealth permanently. He says the simplest strategy would be to gear more in cheap markets and less in expensive ones.

"Gearing an inherently risky asset class like shares is not for the faint-hearted," Coggins says. "Investors must consider the outlook for the market and current valuations. I would challenge the view that gearing is more appropriate following a six-year bull market in global shares."

Stock-picking skills

If you were lucky enough to have invested near the bottom of the market on January 1, 2009, you would have enjoyed big gains. There was, however, wide divergence between the performance of individual managers. For example, an original $100,000 investment in the Perpetual geared share fund would be worth about $400,000 today versus $227,000 for BT and $285,000 for Colonial First State.

What this highlights is how much of an impact the factors of gearing, the level of gearing and the underlying skill of the stock picker can have on the performance of your investment. At face value, Perpetual appeared to be a better stock picker and when geared, those gains are magnified again. Since there's a clear divergence between the best-performing active geared strategy and the worst, it's critical to get the fund manager call right, Coggins says.

When the market is looking fully valued, gearing can be a dangerous strategy, experts say. At the start of the new financial year, with the market down more than 10 per cent from its April peak, it looks less "toppy". But more falls could be on the cards.

Paul Moore from PM Capital notes that with forward looking P/E ratios still above 16 times, gearing is far from a sure thing."You don't want to gear after returns have been strong, and global equities currently provide better medium-term risk/reward opportunities, with currency adding an extra kicker."

Debt recycling

If lending activity is any proxy, investor appetite for gearing into the sharemarket right now appears low. While CommSec is opening about 2000 new trading accounts a week, Phelps says only a small percentage are taking out margins loans.

Travis Adams, equity specialist with Prescott Securities, suspects that a growing number of investors are borrowing against home equity to gear into shares. While any form of gearing has its risks, Adams says recycling a private home loan into a debt on which the interest is tax-deductible has a lot of merit. For those without home equity, Adams says a margin loan might be an option. But with the scars of the global financial crisis still vivid in investor memories, he warns clients to tread carefully.

With most clients unwilling to consider margin loans, Adams says the two geared share funds on the company's preferred product list (the Ausbil Investment Trust – Australian Geared Equity Fund, and the Perpetual Wholesale Geared Australian Share Fund) are proving more attractive.

"We have a fluid inflow of client money into these two funds, and typically from young accumulators who like the idea of a specialist manager acquiring investments on their behalf."

One issue that should be front of mind for any investor looking for a recommendation into a geared share fund is what's driving the recommendation.

Wayne Leggett, of Paramount Financial Services, concedes anyone looking to be guided into the right geared fund may have to go beyond their adviser to find it. "Clients of advisers may only have the options on a dealer group's preferred product list, which in most cases will be very limited."

This article first appeared on www.afrsmartinvestor.com.au

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