Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 340

Duh! Of course geared funds won, but know the risks

When The Australian Financial Review published an article called, "Australia's best fundies for 2019" on 14 January 2020, it was obviously highly popular with readers. Who doesn't love a winner?

But half of the funds listed in the Top 10 'All Funds Report' based on Morningstar's database of 9,846 funds were geared funds. Well, duh! The S&P/ASX200 Accumulation Index was up 18.8% in 2019 and geared fund borrowing costs fell to about 2%. Of course cheap leverage pays off when markets are so strong.

With many investors thinking the good times will continue, there's a temptation to gear into the action, especially with borrowing costs low. What can go wrong? 

How do investors gear into shares?

There are four main ways to borrow to invest in shares:

1. Margin loans, where the assets secure the loan but the borrower remains responsible for any shortfalls.

2. Drawings against the equity in home loans, where the loan is secured against the value of residential property.

3. Instalment warrants, where one payment is made on first investment, and then the investor can choose to make a later second payment to achieve full ownership.

4. Internally geared share funds, where the borrowing and security are managed within the fund itself with no recourse to the investor. These are the successful funds of 2019 referred to in the AFR article.

Here we focus on how geared funds work, and show the asymmetric returns.

How does gearing work?

Let's consider if the market index rises or falls 10%, how much will a geared strategy change in value?

Surely, that’s easy. Assuming a gearing ratio of 50%, if I borrow $100,000 to add to my own $100,000 and invest $200,000, don’t I simply double the return? And if the market is down 10%, then my return will be down twice as much, or 20%. I can live with that risk, so let’s go.

Sorry, it doesn't work like that.

Internally geared funds build the debt into fund structure. For example, a fund geared at 60% (the usual maximum allowed) will take $10,000 from an investor and borrow another $15,000 to invest $25,000 on behalf of the unitholder ($15,000/$25,000=60%). The interest cost is significantly lower than in margin lending because these funds borrow in wholesale markets, currently at around Bank Bill Rate plus 1%, or 2%. However, management fees are charged on the gross assets (including the borrowed amount), so geared funds gross up the fees handsomely. 

The calculation which many geared investors overlook

For a geared strategy to be worthwhile, the ungeared (or market) return must be enough to cover the interest cost plus any management costs and fees. Let's consider what happens in a strong market, which rises 10% in a year. 

The formula, which can apply to any geared investment, is:

Geared Return = (Ungeared Return – Gross Fees) - (Gearing Ratio x Interest Cost)
(1–Gearing Ratio)

The gearing ratio is the amount of debt as a proportion of total assets, and if an investor puts in $40 and the fund borrows $60 on their behalf, the gearing ratio is 60%. Interest is only paid on the borrowed amount, so the lower the gearing, the less the impact of the borrowing rate. This calculation ignores the fact that income may be taxable and expenses may be deductible.

Let's use a typical example of a geared share fund with an interest cost of 2%, a gearing ratio of 60% and fees on the gross assets of the fund of 1%. Assume the normal accumulation index (price plus dividends) rises 10% over a year.

The Geared Return will be 19.5%, being 9% return after fees (10%-1%), less the interest cost (60% of 2% is 1.2%), leaving 7.8% net return, divided by the 40% equity put in by the investor, to give 19.5% (7.8%/0.4).

(The impact of low rates is significant. If the funding cost was say 5%, the return would drop to 15%).

However, here's where the risks come in. If the market is flat, the Geared Return would be -5.5%, being the cost of 1% in fees and 2% interest, divided by the capital of 40% (-2.2%/0.4=-5.5%).

Note that these examples consider total returns, so ‘flat market’ means prices have fallen enough to offset the dividends.

If the index falls 10%, the ‘loss’ on the investor’s capital is a hefty 30.5%

The asymmetry of returns can shock investors. 

How can the loss be over 30% when the market is down only 10%? It does not seem intuitively correct. 

Consider the exact dollars. An investor puts in $100,000 and borrows $150,000 to invest $250,000. The portfolio is down 10% or $25,000. The fund charges 1% on gross assets or $2,500 and the interest cost is $3,000 ($150,000 at 2%). That’s a loss of $30,500 or 30.5% on $100,000. Oops.

By the same reasoning, many investors with margin loans during the GFC in 2007 lost 100%, even when gearing ratios were lower. They put in $100,000 and borrowed $100,000, and then their shares fell in value by 50%. Their loss was not 50%, it was 100%. All their capital was gone.

Here are the geared returns on a typical geared share fund for various levels of (ungeared) market performance (the same calculations apply to any form of gearing).

Accumulation Index (Ungeared) Geared Return Gearing Ratio (debt/assets) Gross Asset Fee Interest Cost
-20% -55.5% 60% 1% 2%
-10% -30.5% 60% 1% 2%
0% -5.5% 60% 1% 2%
5% 7.0% 60% 1% 2%
10% 19.5% 60% 1% 2%
20% 44.5% 60% 1% 2%

The point where geared equals ungeared is when the normal market is up about 3.6%, enough to cover the costs and provide an equivalent return. 

A margin loan invested on the ASX in, say, cheaper Exchange Traded Funds (ETFs) or direct shares may save on the asset management fee, but the borrowing cost is much higher, making the geared returns even worse. According to Canstar, margin loan rates are currently between 4.75% and 6.73%, way above the 2% on internally geared funds. 

For example, if the market loses 10%, an investor with a margin loan at 6% would lose 33.5%. 

A geared investor needs high risk tolerance

Gearing is not for the fainthearted, especially when low equity returns are a more realistic expectation. A gearing ratio of 60% will give an investment with 250% of the volatility of the standard equity index.

The same reasoning as above applies to any geared investment, including buying the family home. Residential owners are blessed by not having daily market valuations, so they do not realise when their geared exposure has made a massive loss. Plus they tend to consider property investment longer term, especially the house they live in.

This leads to the type of mindset you need to gear into equities. It is for the highly-risk tolerant and based on a long-term strategy, because short-term losses can be severe.

Also, borrowing within super is complex and expensive, and an SMSF may not be the best structure to learn whether you have the risk tolerance.

Any gearing structure should watch for gearing on gearing. Although almost all listed companies have some level of borrowing, property funds were historically highly geared going into the GFC, and the major feature of their subsequent restructuring has been to move to lower gearing levels.

Investors need far better performance to recover from a fall than the percentage fall itself. For example, if a $1 investment goes to 50 cents, it has fallen by 50%. But to recover from 50 cents to $1, it must rise 100%. 

Next time an adviser or broker suggests an equity loan or internally geared fund, ask a simple question:

“If the market goes down only 10%, how much will I lose?”

If they don't know the answer, they will be shocked when you show them this article.

 

Graham Hand is Managing Editor of Firstlinks. He was General Manager, Funding & Alliances at Colonial First State, during the GFC, where he was responsible for gearing management (not asset selection). At its peak, CFS's geared funds held $10 billion in assets. Nothing in this article constitutes personal financial advice or considers the circumsances of any individual.

 

5 Comments
Brendan Colley
October 30, 2020

Great article thanks for writing.

James
March 20, 2020

Graham, I have an investment in a geared global fund but they don’t reveal their gearing rate but I can guestimate it from observed price changes. They won’t tell me the gearing ratio or whether it changes or let me speak with fund itself.

My question is whether I can be wiped out by a large equity rout or whether they would just change to no gearing. I understand you are now else where and also don’t offer specific advice.

Graham Hand
March 20, 2020

Hi James

You are correct that I cannot offer personal advice but I can make some general observations about geared funds. This article explains how geared funds work. In my opinion, they should maintain the gearing as described in the PDS and not reduce it to zero. Imagine if the market fell 20%, then they reduced the gearing to zero, then the market rose 20% and the fund was ungeared during the rise. Investors would rightly criticise them for incurring a geared loss but not a geared recovery.

In the example of Colonial First State, they do advise the 'target gearing' on their global funds:

"In the case of the FirstChoice Wholesale Geared Global Share option, the target gearing is 33.3%, with a usual tolerance of 5%. In the case of the other two global options, the target gearing is 55%, with a usual tolerance of 5%. The different target gearing gives investors a choice in the level of gearing available from the global options, from the lower risk 33.3% to the higher risk 55%.”




Ramani
January 16, 2020

To all those who spruik the wonders of compound interest in the Funds Management caper, luring credulous customers into areas they should avoid, here is a plea: please warn the punters that it works to their detriment in reverse. Thus a mere 2% pa over 100 years mounts up to an incredible sum, whether it is owed to you or owed by you. As with nature, maths is agnostic to its effect on humans.

Classics like 'it is not timing the market, it is the time in the market' must have their corresponding cautions blazed on bill boards: 'It is not timing your mortgage but your defaulted time with the mortgage that bankrupts you', especially in Australia where (unlike the USA) the lender can pursue the borrower if the collateral is less than the total dues. And no, the Lenders' Mortgage Insurer (paid a hefty single premium at the outset of the mortgage) will not let go, but will sue you for the amount paid out to the lender

Gearing is a sharp double-edged sword. Given the pervasive retail misconduct globally, can we teach these basics at school, please?

Glenn
January 16, 2020

And in the GFC, when property funds were more heavily geared than they are now, geared property funds fell 90% in value. But what a spectacular recovery since then if you timed it right.

 

Leave a Comment:

     

RELATED ARTICLES

The returns to expect from gearing into shares

The best and worst managed fund of all

The decline of margin lending

banner

Most viewed in recent weeks

Unexpected results in our retirement income survey

Who knew? With some surprise results, the Government is on unexpected firm ground in asking people to draw on all their assets in retirement, although the comments show what feisty and informed readers we have.

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

Three all-time best tables for every adviser and investor

It's a remarkable statistic. In any year since 1875, if you had invested in the Australian stock index, turned away and come back eight years later, your average return would be 120% with no negative periods.

The looming excess of housing and why prices will fall

Never stand between Australian households and an uncapped government programme with $3 billion in ‘free money’ to build or renovate their homes. But excess supply is coming with an absence of net migration.

Five stocks that have worked well in our portfolios

Picking macro trends is difficult. What may seem logical and compelling one minute may completely change a few months later. There are better rewards from focussing on identifying the best companies at good prices.

Six COVID opportunist stocks prospering in adversity

Some high-quality companies have emerged even stronger since the onset of COVID and are well placed for outperformance. We call these the ‘COVID Opportunists’ as they are now dominating their specific sectors.

Latest Updates

Retirement

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

Interviews

Sean Fenton on marching to your own investment tune

Is it more difficult to find stocks to short in a rising market? What impact has central bank dominance had over stock selection? How do you combine income and growth in a portfolio? Where are the opportunities?

Compliance

D’oh! DDO rules turn some funds into a punching bag

The Design and Distribution Obligations (DDO) come into effect in two weeks. They will change the way banks promote products, force some small funds to close to new members and push issues into the listed space.

Shares

Dividends, disruption and star performers in FY21 wrap

Company results in FY21 were generally good with some standout results from those thriving in tough conditions. We highlight the companies that delivered some of the best results and our future  expectations.

Fixed interest

Coles no longer happy with the status quo

It used to be Down, Down for prices but the new status quo is Down Down for emissions. Until now, the realm of ESG has been mainly fund managers as 'responsible investors', but companies are now pushing credentials.

Investment strategies

Seven factors driving growth in Managed Accounts

As Managed Accounts surge through $100 billion for the first time, the line between retail, wholesale and institutional capabilities and portfolios continues to blur. Lower costs help with best interest duties.

Retirement

Reader Survey: home values in age pension asset test

Read our article on the family home in the age pension test, with the RBA Governor putting the onus on social security to address house prices and the OECD calling out wealthy pensioners. What is your view?

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.