Geared funds

Gearing and leverage are interchangeable terms used to describe the strategy of borrowing money to invest.

Gearing can be used in relation to most asset classes and may take several different forms. Some of the most common forms of gearing include the following:

Investment loans

Mortgages that are secured over property or the assets that are the subject of the investment. Many Australians choose to ‘negatively gear’ their investments into the property market, meaning that the interest costs of their loan, and other costs associated with the investment, exceed the level of income generated by the property.

Margin loans

The amount you can borrow from a broker is based on the LVR (loan to value ratio) of your existing share or managed fund portfolio. If the value of your security drops (in a market downturn) you may exceed your maximum LVR and be forced to sell down part or all of your portfolio or contribute additional security or cash.

Instalments and other warrants

Generally, an instalment warrant gives the investor the right to buy an underlying asset (usually shares or units in a fund) with an initial part payment and an optional final payment. In between, the holder is entitled to the dividends or distributions, and any franking credits, paid on the underlying shares or units.

Structured products

Tailored or packaged products that typically offer protection for the underlying capital, with dividend or distribution payments often used to pay off the loan amount and cost of protection.

Options and futures

These instruments intrinsically have some form of leverage built into them and can magnify gains and losses.

Internally geared funds

Where the borrowing and security typically are managed within the fund itself, with no recourse to the investor (other than loss of the original capital) should the market value of the secured assets fall.

A benefit of gearing is that it provides an opportunity to increase investment exposure beyond what you currently own. It enables you to access more funds/property than you are able to access otherwise. Over the long term this may help increase your accumulation of wealth.

Leveraged funds, or geared funds, are designed to achieve a magnified or greater investment exposure than an ungeared fund or ETF.

A leveraged fund can offer either short or long exposure to benchmark indices.

For example, the GEAR (Geared Australian Equities Complex ETF)
provides geared long exposure to the returns of the Australian sharemarket (as measured by the S&P/ASX 200 Accumulation Index).

The BBOZ (Australian Equities Strong Bear Complex ETF) provides geared short (or negatively-correlated) exposure to the returns of the Australian sharemarket (as measured by S&P/ASX 200 Accumulation Index).

There’s also the BBUS (US Equities Strong Bear Currency Hedged Complex ETF) which provides geared short (or negatively-correlated) exposure to the returns of the U.S. sharemarket (as measured by the S&P 500 Total Return Index).

Leveraged funds use derivatives or debt to magnify – often by two or three times – the daily returns (whether positive or negative) of an asset class or index.

To compare, an ordinary ETF generally tracks the underlying securities of an index 1:1, while a leveraged fund may aim for a 2:1 or 3:1 ratio.

Take the actively managed GEAR (Geared Australian Equities Complex ETF) as an example.

GEAR combines funds received from investors with borrowed funds and invests the proceeds in a broadly diversified share portfolio. The fund is ‘internally’ geared meaning all gearing obligations are met by the fund.

The fund’s gearing ratio (the total amount borrowed expressed as a percentage of the total assets of the fund) is managed between 50-65% and rebalanced to the mid-point when these levels are breached.

This means that if the portfolio increases in value the loan to value ratio will fall. To rebalance the gearing ratio, the fund will borrow more and buy additional fund assets. Conversely, if the portfolio value falls, the fund will be required to sell down its assets and lower the loan amount within the portfolio.

Gearing levels are actively monitored and adjusted to stay within this range, and managed with the objective of ensuring that income from the underlying share portfolio is sufficient to meet the borrowing costs so that the fund will be ‘positively geared’.

As gearing obligations are met by the fund, there are no margin calls or credit check requirements for investors, and investors cannot lose more than their initial capital outlay.

Some funds achieve gearing through the use of futures. For example, the AUDS Strong Australian Dollar Complex ETF  invests in cash and cash equivalents and buys Australian dollar / U.S. dollar exchange-traded futures contracts (AUD/USD futures).

Buying these futures can typically be expected to generate a positive return when the Australian dollar strengthens against the U.S. dollar (and a negative return when the Australian dollar weakens against the U.S. dollar).

The fund does not borrow for investment purposes, but instead uses AUD/USD futures to obtain a geared or magnified exposure, which generally varies between 200% and 275% on a given day.

The fund’s returns will not necessarily be in the expected range over periods longer than a day due to the effects of rebalancing and compounding of investment returns over time. Investors will need to monitor their investment frequently to ensure it continues to meet their investment objectives.

Ease of access

All Betashares geared funds are bought and sold on the ASX like any share, meaning there is no need for any loan agreements as for margin loans or any additional paperwork beyond normal share investing.

No margin calls for investors

As all gearing obligations are met by the Betashares geared gunds, investors in these funds are not exposed to the risk of any potential margin calls, with downside risk being limited to the amount originally invested, unlike margin loans or CFDs. A margin call is essentially a notice from the broker for an investor to either add cash to the margin account or sell their position/s to bring an account back to a required level. If this isn’t met by the investor, a broker can liquidate the assets in the account without investor approval.

Cost-effective

Betashares implements its gearing strategy by the use of institutionally priced loans, which are priced at substantial discounts to those available to most investors, or via the use of futures, which are a very capital efficient way to obtain geared exposure.

SMSF eligible

All Betashares geared funds are SMSF eligible and can be used as a means to access gearing in SMSFs/super as a component of a diversified portfolio.

Transparency

The daily gearing ratio or portfolio exposure of each of the Betashares geared funds is available on the relevant fund page on the Betashares website and is updated daily.

It is essential to note that gearing magnifies both gains and losses – if the market falls, leveraged investments can be expected to produce magnified losses.

Whilst geared investments can present a great opportunity it should also be noted there is a degree of asymmetry to the returns.

Given this volatility compared to ungeared investments, geared strategies may not be suitable for all investors. Investors should be willing to accept higher levels of investment volatility and potentially large moves (both up and down) in the value of their investment. Investors should seek professional financial advice before considering any geared strategy and monitor their investment actively.

Some investors may use gearing to attempt to time the market and maximise their position in an asset when the security price is at a perceived low point. It may also enable investors to broaden their asset allocation.By gearing into one asset class, an investor may have the scope to invest their remaining cash in a different asset class. For example, some SMSFs that have invested heavily in property may consider using geared funds to broaden their exposure to other asset classes.

Clients who have set longer term retirement objectives may also consider gearing to bridge a shortfall in their accumulated assets given that gearing may magnify gains (but subject to the risk that such strategy may also magnify losses).