This article was produced in partnership with First Sentier Investors.
Gearing has long been a popular wealth creation tool. Investors are especially attracted to leveraged managed funds which can provide an additional layer of risk management and offer a lower cost of debt versus DIY gearing options, in addition to their potential to generate outperformance. Notwithstanding that leverage adds to the risk profile of the investment, which needs to be carefully considered as gearing is not the right strategy for all.
First Sentier Investors deputy head of Australian equities growth David Wilson tells Professional Planner there’s strong demand for investment options that offer gearing.
Gearing an investment refers to the use of borrowed funds to increase the potential return on investment, essentially amplifying potential gains and also losses, by investing more than the original capital invested by the client.
First Sentier Investors has managed a Geared Share strategy since 1997, which Wilson has helmed since 2017. It launched a new fund under Wilson’s management in 2023. “The strategy has a long history and a very deep understanding among financial advisers,” he says.
Three investor types tend to gravitate towards geared investments, the first being financial planners, “It’s very common for advisers to invest their own money in the fund,” Wilson says.
“Secondly, it can be attractive for younger investors with a high-risk tolerance who appreciate they have time on their side to ride through a number of market cycles and can use gearing as a way to build wealth. Gearing is also popular with affluent investors who can tolerate a degree of volatility in their portfolio.”
Tony Sarai, director of executive planners and head of the Modoras Group Investment Committee, agrees client demand for geared investments has been consistent for a decade and attracts a wide variety of clients.
“Some retirees are very comfortable with gearing because they have the capital behind them and they want to continue to grow their portfolio to look after future generations,” Sarai says.
“Whereas young accumulators may be looking to save for a deposit for that new home five or seven years down the track and want to borrow to achieve that.”
Understanding gearing’s pros and cons
Investors can gear portfolios in lots of ways and these options have pluses and minuses.
A key benefit of leveraged managed funds is that investors can benefit from access to professional fund managers who can help manage the extra risks that come with gearing and also access a cheaper cost of debt.
“We borrow at institutional rates which can almost halve the borrowing cost of a margin loan available to retail investors – there’s a major advantage there,” Wilson says.
“We also meet the margin call during market drawdowns and investors are never asked to come up with more capital. We’re actively managed, which means you don’t inherit the market weightings in the index and we can put together a portfolio that suits the level of gearing.”
There are some situations when it makes sense for investors to manage their own gearing, for instance if they have a view about an investment outside the top 100 Australian equities. In that case, the investor might take out a leveraged loan.
“But even if you’re borrowing via your home mortgage, the interest rate will be above the rate the fund pays,” Wilson says.
Active management in a leveraged managed fund allows for risks to be professionally mitigated as the portfolio can be constructed and managed in a way that is uniquely accommodating of the gearing that sits behind the investment.
“Liquidity is the main risk, because if the market falls, we’re required to reduce our gearing levels to 55 per cent. Sometimes we need to sell shares to manage that liquidity,” he says.
Another risk is a falling bourse, but Wilson and his team have form riding out market corrections.
“We had the fastest 30 per cent decline ever at the early stages of the Covid-19 pandemic, when the market fell by 30 per cent in 19 days,” Wilson says.
“But our fund had ample liquidity because it only invests in ASX 100 companies. Despite the very fast fall in the market, there were never problems paying down debt during that period.”
In fact, turbulent markets can be buying opportunities for leveraged managed funds.
“There are distortions in the market when share prices fall quickly, so we try to take advantage of those situations,” Wilson says.
What to look for in a geared fund
Choosing a geared managed fund that invests in a mix of growth stocks and quality stocks can deliver investors the long-term benefits of leverage, in combination with the returns markets generate over time. But it’s important to choose the right shares to reduce the fund’s risks.
“We don’t want too much volatility in the earnings profiles of the stocks in a geared fund,” Wilson says.
“We also don’t want ‘leverage on leverage’ meaning we have a preference against buying companies with balance sheets that are highly geared themselves, because this has the potential to compound any potential loss.”
“Australia is a good place to invest in a leveraged fund because we have a broad selection of quality companies we can invest in, including banks, retailers, supermarkets, insurance companies and miners. Beyond that, we have plenty of high growth companies, such as CSL, James Hardie and ResMed and even the newer tech names, like WiseTech and Xero. It’s a very high-quality environment.”
But, gearing is not for everybody, so it’s important the strategy is appropriate for the investor’s risk profile and nature.
Sarai says investors have to be comfortable living through different market cycles.
“It can be a roller coaster, so you need to manage the financial and emotional aspects of it,” Sarai says.
Falling markets happen and one of many roles an adviser plays is helping clients prepare for downturns.
“When you have a good run in the market, you have to temper that expectation among clients as well,” he says.
Sarai says it’s about making sure gearing is right for the investor and it’s not solely being used to generate good returns. There is volatility to consider and if the client has an appetite for that.
“Having the right strategy in place and making sure there is a cash reserve, and a steady cash flow is what to look for in a managed fund,” Sarai says.
“It’s not all about returns, because returns go up and down. Look at funds-under-management, rates and fees, liquidity of the fund and the management team. Also, make sure when you take away the leverage component, the fund is true to label.”
Gearing can be a good choice for investors who want enhanced returns. But it’s important to approach it with a well-informed strategy that matches their goals and risk tolerance, to balance out rewards and risks.
