Gearing for a great portfolio

Our guide to geared share products that help you build a bigger portfolio.

Summary: Investors are comfortable gearing into property, but are less so into shares despite it being equally tax effective and also open to negative gearing. With that in mind, there are five main ways investors can gear into shares: through margin lending, internally geared share funds, ASX listed instalment warrants, protected lending and synthetic gearing products.

Key take-out: Flexibility is key to successful gearing. Buying good stocks with prospects for earnings (and share price) growth using an efficient gearing facility can be a great way to grow your wealth. Make sure that you continue to monitor your investment, and close out positions where the fundamentals of a stock have severely deteriorated.

Key beneficiaries: General investors. Category: Investment portfolio construction.

Australians have no problem becoming landlords and gearing into property. Gearing into shares, though equally as tax effective and open to ‘negative gearing’, has been less popular of late.  We understand the ‘landord effect’ in residential real estate; it’s time to look at it again in the context of the share market.

Apart from borrowing against the equity in your home (or a rental property) to invest in the share market, there are five main types of gearing:

  • Margin lending
  • Internally geared share funds
  • ASX listed instalment warrants
  • Protected lending
  • Synthetic gearing products, constructed using derivatives.

1. Margin lending

Margin loans and internally geared share funds suffer from a lack of investor control: when the share price falls to the level where the lender’s outlay is at risk, the lender will sell down some or all of the shares to protect its capital. Even if the investor has been meeting its interest payment obligations (in the geared share fund the provider uses dividends to cover costs), if the share price falls, the investor is at risk of losing stocks, as well as the outlay they contributed to commence the strategy. These products work well in rising markets, but suffer when share prices fall (even if dividends have grown).

Margin lending allows more flexibility than internally geared share funds, since the investor can set the level of gearing (ie the “loan to value ratio”) to a conservative level as well as maintaining the loan amount if the share price rises. In that case, the LVR will fall in line with share price gains, reducing the risk of a margin call being made. Internally geared share funds are riskier because they maintain a set LVR which means they will increase the size of the loan book within the fund as share prices rise.

Margin loans are now available over a wide range of ASX listed stocks with interest costs around 5-6 per cent per annum, and with some providers offering access to selected international stocks as well. Margin lenders like Adelaide Bendigo Bank also lend against a growing range of ETFs, making the job of selecting the underlying stocks easier. Setting LVRs below 50 per cent significantly reduces risk of a margin call and moves the overall cash flow close to being neutrally or positively geared.

Even modest dividend growth will push conservatively geared margin loans into positively geared territory within a short period of time. By using excess dividends to pay down the loan, interest costs and LVR levels will fall significantly, with the overall benefit of extinguishing the debt and reducing the payback period. That can help to immunise the margin loan from the risk of share prices falling.

2. Internally geared funds

There are a range of well- known internally geared funds such as Colonial First State Geared Fund and the Perpetual Geared Australian Share Fund: the fund takes on the gearing, rather than the retail investor.

Interest costs for internally geared share funds are normally around the same levels as margin loans although BetaShares offers its internally geared ASX 200 ETF (ASX code: GEAR) with a far cheaper interest cost, currently less than 3 per cent pa.

One drawback of these funds compared to margin loans is that tax deductions for interest costs are not available to investors in internally geared share funds. Clearly these funds are not tax driven!

The next 3 products remove or reduce the risk of forced sell down in falling markets. Each of them are eligible for use within SMSF’s as well as by individual investors, and because of their “limited recourse” security structure they can be significantly less risky than margin loans or internally geared share funds.

3.  Instalment warrants

Instalment warrants pioneered the technology now more widely used in SMSF gearing structures, with the first instalment product issued by the Commonwealth Government to sell down CBA in 1995. Instalments require the investor to pay something up front (the first instalment) with a loan embedded within the product (which the investor can choose to repay by making a final instalment). The beauty is that the payment of the final instalment is optional – if it is not repaid, the lender cannot sue for its payment (but the investor will forfeit the money initially outlaid in the first instalment).

Whilst this can provide the platform for lower risk investing compared to paying for shares in full, the problem arises if the investor outlays most or all of their savings, and then forfeits that by choosing not to repay the final instalment. That would typically happen when the underlying share price has fallen by more than the amount of the final instalment. So although instalments give the investor more control compared to margin loans or internally geared share funds, they can still result in capital losses and this should be considered as part of the overall investment strategy.

Instalments are bought and sold on the ASX, with LVRs ranging from around 50 per cent up to 100 per cent. There are no minimum investment amounts for instalments, and with the massive range of shares and ETFs available within the instalment market, these products truly do democratise share gearing for the masses. Instalments are issued by providers like UBS and Citibank, with CBA recently announcing its exit from this market (more on this below).

Instalments may use put options to protect against price falls, with some using a “stop loss” facility that behaves similarly to the forced sell down of stocks in margin loans. Instalments include up-front interest costs for the first year within the price of the first instalment, with subsequent year/s interest being capitalized (added back to the loan amount). Some instalments use dividends to reduce the loan amount, and these “self funding” instalments can be a great way to accelerate the payback period (when underlying stocks pay good levels of dividends).

4. Protected loans

The risk of capital loss can be removed by using a protected loan (or instalment) where the LVR is 100 per cent, in which case the investor is not required to make any capital outlay to establish the facility. Instead, the interest cost is higher than a margin loan or less-geared instalment – so they involve a clear trade off between initial costs and capital risk.

CBA announced its withdrawal from the protected loan market last week, apparently in response to a cost cutting program imposed after announcing flat third-quarter earnings. That leaves ANZ, UBS and Macquarie as the main providers of protected loans, with interest rates above 10 per cent pa for most stocks. ANZ’s “COBALT” protected loan facility permits gearing against international shares, and all these providers allow the investor to cap their upside to reduce loan interest costs to well below 10 per cent pa.

Setting a cap at an annual level which is well above current share prices (say 10 per cent or more) won’t be a real problem, unless stocks rise strongly during the year. Check the cashflow and tax calculators for stocks that you are interested in, to assess their net costs and “break even” levels.

Tax deductions for interest costs are capped at the RBA secured home mortgage interest rate (check this with your lender). If you buy a portfolio of stocks with a protected loan, check how much flexibility you have to sell down individual stocks within the loan term – getting locked in to funding a losing position should be avoided. Borrowing for 1 year periods is a good way to add flexibility – at the end of each year you can decide which stocks to exit, and positions to renew.

ANZ and UBS only offer protected loans with large face values (around $500k to begin with), so these can be quite daunting for first time or smaller investors. Protected loans do enable a range of strategies, including migrating positions which have accumulated profits to lower cost margin loans, or taking profits to generate funds to pay off loans.

5. Synthetic loans

Macquarie pioneered these several years ago with its FLEXI 100 facility. This involves the issue of units which are linked to the performance of a wide range of indices and assets, which pay a small preset “coupon” and which must be purchased using a loan provided by Macquarie. They are structured using derivatives – hence they don’t pay franked dividends – and have a fixed term, at the end of which the loan is repaid and the investor is left with any surplus. Interest rates are around the same levels as margin loans – check these with Macquarie.

Some series of FLEXI have performance caps whilst others don’t start generating profits unless an investment hurdle is reached – so beware of the precise payoff profile of any series of these that you invest in. Unlike other geared share investments, all of the payments on FLEXI 100 products are treated as fully taxable income – this includes any final payments linked to capital growth.

FLEXI 100 was created to allow investors the flexibility to “walk away” from their investment without any capital loss, so as to limit ongoing liability for interest payments in the event that investment prices have fallen. This is a powerful feature, which can also be replicated using protected loans with a one year term.

Think strategically

Flexibility is key to successful gearing. Buying good stocks with prospects for earnings (and share price) growth using an efficient gearing facility can be a great way to grow your wealth. Make sure that you continue to monitor your investment, and close out positions where the fundamentals of a stock have severely deteriorated. If you have used a facility with a high LVR you will be able to do so with limited capital loss, so you can think of the higher interest expense for high LVR loans as a payment for this flexibility.

Smaller investors can access gearing through the ASX instalment market, which is like buying shares on “lay-buy” with the benefit of locking in your entry price at current levels. If you avoid the idea of using gearing as a way to create short term speculative profits, and focus on long term strategies based around the “landlord effect,” you will lay the foundations for a great portfolio.


Dr Tony Rumble provides asset consulting services to financial product providers and educational services to BetaShares Capital Limited, an ETF provider. The author does not receive any pecuniary benefit from the products reviewed. 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.