Gearing: Choosing managed funds to do the work

If you don't want to gear directly into the share market by taking a loan to buy shares there is a “middle way”. I've written recently on the outstanding numbers that present themselves at present with low interest rates and relatively high dividend yields available on the ASX (see Got the guts to gear?, February 18).

One choice worth examining is to “outsource” the worries of borrowing money and managing an investment portfolio, and instead use a geared managed fund.

In these funds all the hard work is done for you. The fund borrows money on behalf of investors and manages the underlying portfolio of shares. This might suit some investors – but the limitations of managed funds as investment vehicles seem to be magnified when borrowed money is added to the equation. These limitations include the impact of fees, the tax inefficiency of managed funds and the tendency of large managed funds to hold portfolios that look very similar to the index – while charging high fees.

The returns

Two of the larger fund managers with geared Australian share funds are Colonial First State and Perpetual. Given the volatility in the Australian share market over the past five years, it is an interesting time period to look back over the returns from these funds. We would expect that over periods of strong market returns a geared fund should outperform and, over poorer periods of returns, underperform. This is the nature of gearing – it increases the volatility of the portfolio and magnifies both good and bad returns.

The funds have provided returns consistent with these expectations. For example, the Perpetual Geared Australian fund (returns to January 31, 2015) provided a return of -6.0% over the past 6 months, during a period when the market return was a fairly lousy 1.2%. 

However, during good times the returns were even more impressive. Over the past three years the average market return was 14% per annum, while the Perpetual fund returned 29.4% pa. Over five years, which is getting very close to capturing the return from the bottom of the market in the GFC in 2009 to now, the fund returned 16.4% pa compared to the average market return of 8.5% pa.

A similar pattern of returns is evident in the performance of the Colonial First State Geared Australian Share – Core fund (returns to December 31, 2014). Over the year to the end of December 2014 the average market return was 6.13%, and the fund return over this period 1.29%. Things look up over three years when the average market return was 16%, a period during which the fund returned 23.7% pa.

But what about the fees?

There is little dispute that fees matter in investing. Perhaps the best recognised academic study on managed fund investing was published in 1997 in the Journal of Finance by Mark Carhart, entitled ‘On Persistence in Mutual (managed) Fund Performance'. He found that funds that tended to consistently perform poorly had higher fees.

As an example of an internally geared fund available in Australia, the Colonial First State Geared Australian Share Fund – Core provides details of both its gross fee (fee across the value of the portfolio – including the borrowed funds) which is 1.91% and net fee, which is the fee based on the value of each person's investment and is a fairly impressive 4.04% per year. 4.04% is a lot of return required just to break even with the fees every year.

Index hugging 

As any managed fund grows in size, it becomes harder for a fund manager to hold meaningful investments in smaller companies. Because of this, it is forced to hold larger holdings in the bigger companies in the market, and it often ends up with holdings very similar to the index – it's a practice known as index hugging.

If an index-style performance comes with an active managed fund fee then the investor is getting the worst of both worlds – high fees with little chance of outperforming the average market return. The following table compares the biggest holdings in the two geared funds we have discussed in the article with the top 10 shares in the index at the moment – there are certainly similarities, especially in the biggest five holdings in each fund which will be the biggest contributors to the fund returns.

The tax inefficiency of managed funds

Tax becomes a crucial issue when you borrow to invest. Generally you are looking for the interest expense from your loan to offset any income earned – to reduce or eliminate any income tax that has to be paid. You also have to think carefully about capital gains tax, selling your investments at a time where the tax liability is not too great. For example, carefully managing sales after assets have been held for 12 months to qualify for the 50% capital gains tax reduction becomes an important strategy – as might selling at a time when you are earning less income, for example after retirement.

Investing through a managed fund means that you give away a lot of tax control. Other investors in the fund – as they add capital or withdraw capital – dictate the timing of many asset sales, which then influences capital gains tax.

This is a problem in all managed funds, however it is amplified in a geared fund. In a normal fund, if an investor with a $20,000 investment withdraws their funds then $20,000 of assets have to be sold and the tax consequences distributed to investors. With a geared fund, and assuming a gearing level in the fund of 50%, a $20,000 withdrawal of funds means that $40,000 worth of investments have to be sold. On one level a geared managed fund actually has scope to “smooth out” the money coming into and out of the fund on a daily basis by subtly changing the gearing level of the fund. Indeed, the distributions (income paid to investors – the return not including capital growth) from the Colonial First State Geared Australian Share – Core fund, which give us some indication of tax efficiency, are quite reasonable, 4.57% after fees per year over the past three years. Many Australian share funds have distribution of 8% per year or more - which investors have to pay tax on. The lack of published “after tax” returns makes it hard to assess the tax efficiency of the fund. The concern for geared funds might be at the time of a sharp market downturn when there might be a large number of investors “heading for the exit” and withdrawing money at the same time – forcing large-scale asset sales in the fund.

A possible place for beginning investors and superannuation investors

One of the advantages of managed funds is that they allow investors who are starting out to invest regularly into a diversified portfolio of assets over time. On this basis, an aggressive investor who is comfortable with the extra volatility of a leveraged share portfolio might start to build assets using a geared Australian share fund. Superannuation investors who are bullish on the share market might also use a geared fund to increase their exposure to Australian shares.

Conclusion

While a geared Australian share fund might suit a small cross section of investors – those starting out and those looking to increase their Australian share exposure in superannuation – for more sophisticated investors the preference will be for them to manage both their loan and investments more directly, to be able to make subtle changes that suit them including selling assets to pay down the loan when it bests suits them, and to keep firm control of the tax benefits and costs of borrowing to invest – as well as reacting to market movements.

Scott Francis is a personal finance commentator, and previously worked as an independent financial adviser. The comments published are not financial product recommendations and may not represent the views of Eureka Report. To the extent that it contains general advice it has been prepared without taking into account your objectives, financial situation or needs. Before acting on it you should consider its appropriateness, having regard to your objectives, financial situation and needs.