Crunching the gearing

More than six years after the barn doors were fully opened, gearing for super funds remains divisive.

Many have not embraced it and would still like to see it banned again. It’s good that it hasn’t been embraced by all – gearing is really only appropriate for higher risk investors.

In any case, it is an investment tool that a growing number of investors are keen to consider.

When it comes to super, gearing opportunities are limited and highly regulated. It is also important to note that SMSFs have greater opportunities than APRA-regulated super funds.

In September 2007, the rules were changed in regards to superannuation and gearing, broadening their potential use. These rules were “refined” in 2010.

So, what are the opportunities for super investors?

There are four main options: geared managed funds; instalment warrants; limited recourse borrowing arrangements; and other structured products.

Geared managed funds

These are managed funds which include an element of internal gearing in the fund itself.

The gearing is usually at approximately 45-55%, depending on interest rates. The fund borrows at cheap wholesale rates and allows investment in Australian and international investments.

It tends to give investors double the bang for their buck. Depending on the fund’s success, if the overall market goes up by 10%, the value of the units in the fund will go up about 20%. The interest bill is paid by the fund manager using dividends and other income from the fund.

This style of investment is potentially available to SMSF and non-SMSF members. SMSFs can access them directly from the fund manager, or through a platform.

But APRA-regulated fund members can access them through retail super fund platforms. (I am not aware of any industry, corporate or government funds that allow geared managed fund investment opportunities.)

Instalment warrants

The old “self-funded instalment warrants” were a favourite of SMSFs for more than a decade. They died in 2008 (see It’s RIP for SFIs) as the world was imploding into the GFC.

Instalment warrants eventually returned, with a makeover.

When warrants are first issued, you pay about half the cost of a share. The other half of the cost is wrapped into a loan, with an interest rate charged by the issuer. The dividends associated are then used to assist in paying down the loan.

This is another investment option potentially available to APRA-fund members. However, I am only aware of a few platforms that allow access to instalment warrant-style products.

The main advantage of warrants over geared funds is you can choose the individual shares you would like to be invested in, rather than having to trust the ability of the fund manager. They can generally be bought and sold on the ASX.

Limited recourse borrowing arrangements (LRBAs)

LRBAs are the gearing opportunities that came into being with the 2007 changes to the super borrowing rules. (However, the terminology LRBA didn’t arrive until the 2010 changes.)

LRBAs are only available to SMSFs. They are the vehicle by which SMSFs can gear directly into residential or commercial property, or directly into listed shares. However, they could be used to invest in any sort of investment that a SMSF can legally invest in (potentially including wine, art coins or cars).

There is a requirement for the asset to be a “single acquirable asset” and that it needs to be housed in a bare trust. This makes property the ideal LRBA investment for most, though particularly large SMSFs could do a diversified share portfolio through LRBAs.

If you’re going to buy a portfolio of shares via LRBA arrangements – for example, BHP, CBA, Telstra and ANZ – the SMSF will need a separate bare trust for each company’s shares to be held, plus the associated loan agreements.

The rules are complex, but there can be tax-saving advantages to other parts of your SMSF (see my earlier article Property Investing for Dummies). Do not attempt these without advice from professionals.

Geared manufactured products

Create a market and there will be no shortage of solutions offered.

And so it is with the renewed interest in gearing products. Many of the major manufacturers (read major banks and investment houses) have “products” that are available to SMSFs. They will consist, in one form or another, of shares or managed funds and an ability to “protect” between 50% and 100% of an initial investment value.

The opportunities can be quite broad, including direct Australian shares, managed funds, international options and some funky sounding alternatives.

To check out these products, look at the websites of most of the major banks.

I’ve looked at most of them. They tend to be expensive. Usually it’s the interest rate associated with the product, but it can often be the fund manager’s fees. Other problems may be limited liquidity or simply that the investments are too exotic.

Bruce Brammall is director of Castellan Financial Consulting and the author of Debt Man Walking. E: bruce@castellanfinancial.com.au

* Gearing is back, are you ready? Join Eureka Report managing editor James Kirby and key Eureka contributors Bruce Brammall and Doug Turek for a very special webcast on Wednesday March 12.